EYE ON THE MARKET
S P E C I A L
E D I T I O N
ag ny &
ecst sy
THE
THE
THE RISKS AND REWARDS OF A CONCENTRATED STOCK POSITION
The Agony and the Ecstasy is a 1961 biographical novel by American author Irving Stone on the life of Michelangelo:
his passion, intensity and perseverance as he created some of the greatest works of the Renaissance period.
Like Michelangelo’s paintings and sculptures, successful businesses are the by-product of inspiration, hard work,
and no small amount of genius. And like the works of the Great Masters, only a small minority stand the test of
time and last over the long run. The Agony and the Ecstasy conveys the disparate outcomes facing concentrated
holders of individual stocks in a world, like Michelangelo’s, that is beset with intrigue, unforeseen risks, intense
competition and uncertainty.
Eye on the Market

J.P. MORGAN
EYE ON THE MARKET • J.P. MORGAN
The Agony and the Ecstasy: The Risks and Rewards of a Concentrated Stock Position
Executive Summary
There are many Horatio Alger stories in the corporate world in which an entrepreneur or
CEO has the right idea at the right time and executes brilliantly on a business plan. But
history also shows that forces both within and outside management control led many of
their businesses to suffer serious reversals of fortune. As a result, many individuals are
known not just for the wealth they created through a concentrated position, but also for
the decision they made to sell, hedge or otherwise take some chips off the table. In this
paper, we take a look at the long history of individual stocks, and at the risks and rewards
of concentration. I first analyzed this topic in detail around ten years ago; since that time,
while some things have changed, the overall song remains the same.
Over the long run, some companies substantially outperform the broad market and maintain their
value. However, the odds have been stacked against the average concentrated holder:
•
Risk of permanent impairment. Using a universe of Russell 3000 companies since 1980,
roughly 40% of all stocks have suffered a permanent 70%+ decline from their peak value. For
Technology, Biotech and Metals & Mining, the numbers were considerably higher.
•
Negative lifetime returns vs. the broad market. The return on the median stock since its
inception vs. an investment in the Russell 3000 Index was -54%. Two-thirds of all stocks
underperformed vs. the Russell 3000 Index, and for 40% of all stocks, their absolute returns were
negative.
•
After incorporating the issue of single stock volatility, we find that 75% of all concentrated
stockholders would have benefited from some amount of diversification.
Another sobering observation: since 1980, over 320 companies were deleted from the S&P 500 for
business distress reasons, which implies a lot of turnover. This should not be a surprise: capitalism is
based on competition, creative destruction and reinvention. While globalization (and in particular,
China’s acceptance into the World Trade Organization in 2001) expanded the opportunities for
individual companies, it also increased their competitive, regulatory and operational risks.
We start with some empirical analysis, and follow with case studies by sector. While the losses on the
stocks in our case studies may seem obvious or inevitable with the benefit of hindsight, in all likelihood
the company’s management, its board of directors, research analysts, credit rating agencies and its
employees all firmly believed in its long-term success.
Michael Cembalest
J.P. Morgan Asset Management
1
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Eye on the Market  J.P. MORGAN
Eye on the market • J.P. Morgan
Table of Contents
Page
Empirical analysis
The steady drumbeat of creative destruction in the S&P 500
3
Falling from grace: catastrophic losses on Russell 3000 companies
4
Success, failure and the distribution of returns on Russell 3000 stocks
6
Why volatility matters and its implications for “optimal” concentrated holdings
8
Sector case studies
Overview
10
Consumer Discretionary
12
Consumer Staples
14
Energy
15
Financials
16
Health Care
19
Industrials
20
Information Technology
21
Materials
25
Telecommunications
26
Utilities
28
Alternative Energy
30
A look at the winners (The Ecstasy)
32
Further considerations
The performance of IPOs vs. the broad market
34
What about taxes?
35
Final thoughts on managing concentrated stock positions
36
Appendix I: on Chinese government subsidies
37
Appendix II: Biotech and Life Sciences
38
Additional information
Sources
39
Acronyms
40
Biography
41
Disclaimer
42
Please note: the results of any particular investment strategy may be uncertain. Particular circumstances may vary,
and other factors may need to be taken into account when deciding on any diversification plan and timing.
2
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Eye on the Market

Eye on the market • J.P. Morgan
J.P. MORGAN
The steady drumbeat of creative destruction in the S&P 500
A simple place to start when thinking about the risk of concentrated stock positions: how often do
their circumstances change? Since 1957, the S&P 500 has served as a proxy for 500 of the largest,
most successful US-domiciled companies. We have compiled a detailed history of its additions and
deletions since 1980, which forms the basis for this part of the analysis. To be clear, not every S&P 500
deletion was the result of a “problem stock”. Actually, most deleted companies were not the result of
a problem, and reflect benign index removals because: they were acquired at a premium to their
current price; they merged with other companies in the index; or, they reincorporated outside the US.
After sorting through the benign deletions, we focused on the rest: the S&P 500 deletions that were
a consequence of stocks that failed outright, were removed due to substantial declines in
their market value, or were acquired after suffering such a decline. As shown below, there
were over 320 of them since 1980. The pace of distress-based deletions rises during a market crisis or
recession, but there is a steady pulse of business failure during the entire business cycle. Consumer
Discretionary, Technology and Financials accounted for the majority of distress-based deletions.
Number of companies removed from the S&P 500 due
to distress by year, Number of companies
Cumulative number of companies removed from the
S&P 500 due to distress, Number of companies
30
350
25
300
250
20
200
15
150
10
100
5
50
0
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013
Source: FactSet, Bloomberg, Standard & Poor's, JPMAM. 2013.
0
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013
Source: FactSet, Bloomberg, Standard & Poor's, JPMAM. 2013.
The spike in index removals during recessions is accurate in time, but misleading in terms of business
risk. Many such companies were much riskier than they seemed during good times, and when the tide
went out with the economy, their operational, financial and competitive weaknesses were revealed.
3
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Eye
on
market
E
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a r k e t  •J . J.P.
P . MMorgan
ORGAN
Falling from grace: catastrophic losses on Russell 3000 companies
The prior section looks at stocks that were deleted from the S&P 500. However, the “distress” rate of
individual stocks is higher than the index deletion rate, since there are stocks that suffer substantial
price declines from which they do not recover, irrespective of whether they remain in an index. And
what about small and mid cap stocks which are not captured by the S&P 500?
To broaden our analysis, we analyzed all stocks that were members of the Russell 3000 at any time
from 1980 to 2014, a database of 13,000 large cap, mid cap and small cap stocks. We then defined
what we believe a concentrated stock holder would see as a catastrophic loss: “a decline of 70% or
more in the price of a stock from its peak, after which there was little recovery such that the
eventual loss from the peak is 60% or more.” How often does this take place? As shown in the
table, 40% of all stocks suffered such a permanent decline from their peak value. Remember, we are
not talking about temporary declines during the tech boom-bust or during the financial crisis, but large,
permanent declines that were not subsequently recovered. Technology, Telecom, Energy and
Consumer Discretionary had the highest loss rates. In terms of subsectors, Biotech (part of Health
Care) and Metals & Mining (part of Materials) had loss rates over 50%.
Total % of companies experiencing
"catastrophic loss",
1980 - 2014
Sector
All sectors
40%
Consumer Discretionary
43%
Consumer Staples
26%
Energy
47%
Materials
34%
Industrials
35%
Health Care
42%
Financials
25%
Information Technology
57%
Telecommunication Services
51%
Utilities
13%
Around 40% of all stocks experienced
catastrophic declines, when defined as a
70% decline from peak value with
minimal recovery. This is a subjective
cutoff point; many concentrated holders
would see smaller permanent declines as
equally unacceptable, and whose risk
should be mitigated. The outcomes
based on a variety of thresholds suggest
that for many concentrated holders,
diversification should be a central part of
wealth management planning.
Source: FactSet, J.P. Morgan Asset Management.
When do such catastrophic declines happen? The next chart shows the percentage of companies at
any given time experiencing a catastrophic loss. These loss rates tend to rise during recessions and
market corrections, but there’s a steady pace of distress even during economic expansions. I don’t
think we should draw too many conclusions from the decline in loss rates in 2010-2013; they have
been dampened by the longest and largest monetary experiment in the history of the Federal Reserve,
during which time the real cost of money has been negative for more than 5 years. There is also a
natural tailing off at the end of the chart, given that there is less time for companies to fail.
Catastrophic loss rates on Russell 3000 companies
% of companies in the process of suffering a catastrophic,
unrecovered loss of 70% or more
The Russell 3000 Index measures the
performance of the largest 3,000 US
companies representing approximately
98% of the investable US equity market.
It is reconstituted annually to ensure that
new and growing companies are
reflected.
20%
15%
10%
5%
0%
1980
1985
1990
1995
2000
2005
2010
Source: FactSet. J.P. Morgan Asset Management.
4
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Eye on the Market

Eye on the market • J.P. Morgan
J.P. MORGAN
When looking at the timing of catastrophic loss rates by sector, a few are similar to the overall market:
Consumer Discretionary, Materials, Health Care and Industrials. Some sectors experience loss rates that
are consistently above (Technology) or below (Staples and Utilities) market levels.
Information Technology: loss rates higher than the R3000
Cons. Staples & Utilities: loss rates lower than the R3000
Companies in the process of suffering a catastrophic, unrecovered loss
Companies in the process of suffering a catastrophic, unrecovered loss
50%
30%
Inf ormation Technology
40%
Consumer Staples
Utilities
Russell 3000
20%
Russell 3000
30%
20%
10%
10%
0%
1980
1985
1990
1995
2000
2005
2010
0%
1980
1985
1990
1995
2000
2005
2010
Source: FactSet. J.P. Morgan Asset Management.
Source: FactSet. J.P. Morgan Asset Management.
Loss rates in Energy, Telecommunications and Financials tell the story of their respective points of
distress. For Energy, the oil price collapse of the early 1980’s and natural gas price collapse of 20082011 were catalysts for rising business failures and falling stock prices, while the energy price rally of
the mid 2000’s reduced loss rates. In the case of Telecommunications, loss rates were lower than the
broad market in the 1980’s and early 1990’s. After the passage of the 1996 Telecommunications Act,
loss rates rose in a deregulated environment (see pages 26-27 for more details in our case study
section). And finally, the last chart shows the spike in Financial sector distress beginning in 2008, and
also during the 1991 recession; outside of these periods, Financial sector distress was lower.
Energy: catastrophic loss rates vs. the Russell 3000
Telecom: catastrophic loss rates vs. the Russell 3000
Companies in the process of suffering a catastrophic, unrecovered loss
Companies in the process of suffering a catastrophic, unrecovered loss
50%
50%
Energy
40%
Telecommunication Services
40%
Russell 3000
30%
30%
20%
20%
10%
10%
0%
1980
1985
1990
1995
2000
2005
2010
Source: FactSet. J.P. Morgan Asset Management.
0%
1980
Russell 3000
1985
1990
1995
2000
2005
2010
Source: FactSet. J.P. Morgan Asset Management.
Financials: catastrophic loss rates vs. the Russell 3000
Companies in the process of suffering a catastrophic, unrecovered loss
30%
A meaningful number of companies are
always in the process of suffering sharp,
unrecovered price declines at any given
time, even during an economic expansion.
Financials
Russell 3000
20%
10%
0%
1980
1985
1990
1995
2000
2005
2010
Source: FactSet. J.P. Morgan Asset Management.
5
5
Eye on the Market

J.P. MORGAN
EYE
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•J . J.P.
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MMORGAN
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Success,
of lifetime returns on Russell 3000 stocks
Focusing
on and
the risk
failure misses
the picture:
theonpotential
of a concentrated
Success, only
failure
theofdistribution
ofhalf
lifetime
returns
Russell rewards
3000 stocks
stock position. There are a number of ways to assess the risks and rewards involved. One approach is
Focusing
on theand
riskcompute
of failuretheir
misses
half the“lifetime”
picture: the
potential
a concentrated
to look atonly
all stocks
respective
price
returnsrewards
vs. the of
Russell
3000 (i.e.,
stock
position.
a number
of ways
to exists
assessinthe
risksform
and rewards
involved.
approach
is
starting
with theThere
time are
when
the company
first
public
and reports
a stockOne
price,
and until
to
at all stocks
compute
theirthe
respective
“lifetime”
price
returns
vs. the Russell
3000other
(i.e.,
its look
last reported
priceand
in 2014
or until
date at which
it was
merged,
acquired
or for some
1
starting
with the
the company
firstresults,
exists inwhich
publiccan
form
reports aas
stock
price, and until
reason delisted
). time
The when
chart below
shows the
be and
summarized
follows:
its last reported price in 2014 or until the date at which it was merged, acquired or for some other
• The median 1stock underperformed the market with an excess lifetime return of -54%. In other
reason delisted ). The chart below shows the results, which can be summarized as follows:
words, in most cases, a concentrated holder would have been better off invested in the market.
• The median stock underperformed the market with an excess lifetime return of -54%. In other
• Two-thirds of all excess returns vs. the Russell 3000 were negative, and for 40% of all
words, in most cases, a concentrated holder would have been better off invested in the market.
stocks, returns were negative in absolute terms.
• Two-thirds of all excess returns vs. the Russell 3000 were negative, and for 40% of all
• Historically, there were some extreme winners: the right tail is ~7% of the universe and includes
stocks, returns were negative in absolute terms.
companies that generated lifetime excess returns more than two standard deviations over the mean.
• Historically, there were some extreme winners: the right tail is ~7% of the universe and includes
Distribution
of excess
lifetime
returns
on individual
stocks
Russell
3000,
1980-2014over the mean.
companies that
generated
lifetime
excess
returns more
thanvs.
two
standard
deviations
Number of stocks
2,100
Distribution
of excess lifetime returns on individual stocks vs. Russell 3000, 1980-2014
Median
Number
of stocks
1,800
0
Extreme winners
Median
Extreme winners
> -450%> -450%
> -400%> -400%
> -350%> -350%
> -300%> -300%
> -250%> -250%
> -200%> -200%
> -150%> -150%
> -100%> -100%
> -50% > -50%
> 0% > 0%
> 50% > 50%
> 100% > 100%
> 150% > 150%
> 200% > 200%
> 250% > 250%
> 300% > 300%
> 350% > 350%
> 400% > 400%
> 450% > 450%
> 500% > 500%
> 550% > 550%
> 600% > 600%
> 650% > 650%
> 700% > 700%
> 750% > 750%
> 800% > 800%
> 850% > 850%
> 900% > 900%
> 950% > 950%
> 1000%> 1000%
> 1050%> 1050%
> 1100%> 1100%
> 1150%> 1150%
> 1200%> 1200%
> 1250%> 1250%
> 1300%> 1300%
> 1350%> 1350%
> 1400%> 1400%
> 1450%> 1450%
> 1500%> 1500%
> 1550%> 1550%
> 1600%> 1600%
> 1650%> 1650%
> 1700%> 1700%
> 1750%> 1750%
> 1800%> 1800%
> 1850%> 1850%
> 1900%> 1900%
> 1950%> 1950%
> 2000%> 2000%
> 2050%> 2050%
2,100
1,500
1,800
1,200
1,500
900
1,200
600
900
300
600
0
300
Time-adjusted lifetime price return on each stock vs. the Russell 3000 Index
Source: FactSet, J.P. Morgan Asset Management.
Time-adjusted lifetime price return on each stock vs. the Russell 3000 Index
The
relative
frequency
of success
and failure shown above is not sensitive to when companies were
Source:
FactSet,
J.P. Morgan Asset
Management.
created. For example, in one scenario, we excluded all Technology, Biotech and other companies that
The
of success
and failure
is not
to when
companies
wentrelative
public frequency
between 1995
and 2000
in ordershown
to testabove
whether
thesensitive
subsequent
collapse
in manywere
of them
created.
For example,
one
we excluded
all not;
Technology,
Biotech
and other
had an outsized
impactinon
thescenario,
results above.
They do
even when
excluding
thesecompanies
companies,that
the
went
public
between
1995 andthe
2000
in order of
to companies
test whether
the subsequent the
collapse
of them
median
return
is still negative,
percentage
underperforming
indexinismany
still around
had
an outsized
impact
on the results
above.
They
do not; even when excluding these companies, the
two-thirds,
and the
percentage
of winners
is still
7%.
median return is still negative, the percentage of companies underperforming the index is still around
two-thirds, and the percentage of winners is still 7%.
1
We compare stock price returns to Russell 3000 price returns. When including the impact of dividends on both
individual stocks and the Russell 3000, the results do not change materially, even for the Utilities sector.
1
We compare stock price returns to Russell 3000 price returns. When including the impact of dividends on both
6individual stocks and the Russell 3000, the results do not change materially, even for the Utilities sector.
6
6
E ye o n t h e M a r k e t

J.P. MORGAN
Eye on
the returns
market
J.P. Morgan
across most sectors. As shown
below,
on• the
median stock were negative in each sector; 60%-70% of stocks in most sectors generated lifetime
2
excess
returns less than
the Russell is
3000
; a third
or more
negative
returns;
and on
The
success/failure
distribution
similar
across
most generated
sectors. As
shownabsolute
below, excess
returns
aside
from Consumer
the
extreme winners
was
single
digits.
the
median
stock wereStaples,
negative
in percentage
each sector;of60%-70%
of stocks
in in
most
sectors
generated lifetime
excess returns less than the Russell 3000 2; a third or more generated negative absolute returns; and
Analysis of lifetime returns by sector, 1980-2014
aside from Consumer Staples, the percentage of extreme winners was in single digits.
E
y e osuccess/failure
n t h e M a r k e t distribution
J . P . M O R G Ais
N similar
The
Median excess
Percentage of stocks Percentage of stocks
with negative
EXCESS
returns
ABSOLUTE
stocks
Percentage of stocks Percentage ofreturns
with negative
with negative
64%
40%
ABSOLUTE
EXCESS
returns
65%
44% returns
Analysis of lifetime returnsreturn
by sector,
1980-2014with negative
vs Russell
3000
Sector
Median
excess
return-54%
vs Russell
All Sectors
3000
Sector
Consumer Discretionary
-62%
All
Sectors Staples
-54%
Consumer
-3%
Consumer
Discretionary
-62%
Energy
-93%
Consumer
-3%
Materials Staples
-73%
Energy
-93%
Industrials
-58%
Materials
-73%
Health Care
-39%
Industrials
-58%
Financials
-21%
Health
Care Technology
-39%
Information
-63%
Financials
-21%
Telecommunication Services
-57%
Information
Technology
-63%
Utilities
-141%
Telecommunication
Services
-57%
Source:
FactSet. J.P. Morgan
Asset Management.
Utilities
-141%
64%
51%
65%
72%
51%
66%
72%
64%
66%
60%
64%
58%
60%
71%
58%
68%
71%
85%
68%
85%
Source: FactSet.
J.P. Morgan
Asset Management.
Here’s
a synthesis
of what
we have done so far. Cisco Systems
40%
26%
44%
48%
26%
34%
48%
37%
34%
42%
37%
30%
42%
53%
30%
54%
53%
14%
54%
14%
Percentage of
extreme winner
stocks of
Percentage
extreme
7%winner
stocks
7%
7%
15%
7%
6%
15%
8%
6%
7%
8%
7%
6%
8%
6%
6%
6%
0%
6%
0%
Stock price
The first step measured the frequency of a stock
$80
price suffering
a catastrophic
is aso far. Cisco
Here’s
a synthesis
of what decline.
we haveThis
done
Systems
$70
Eventual loss from
Stock price
painful
however, the
some
concentrated
holders
The
firstevent;
step measured
frequency
of a stock
peak of: -67%
$60
$80
price
a catastrophic
decline. Thismarket
is a
mightsuffering
say, “a decline
from unsustainable
$50
$70
Eventual loss from
Max loss from
painful
event;
some
concentrated
valuations
washowever,
painful, but
I still
benefited holders
peak of: -67%
$40
peak
of:
-86%
$60
might
say, “afrom
decline
from
unsustainable
market
substantially
being
concentrated
in the
stock.
Since inception stock
$30 price return of 27%
$50
valuations
painful,
butlow,
I stillso
benefited
My originalwas
basis
was very
things turned out
Max loss from
annually vs. market
$20
substantially
from
being
concentrated
the stock.
$40
peak of: -86%
fine in the long
run.”
There
are many in
examples
of
returns
of
8%
Since inception stock
this original
paradigm,
particularly
in Technology.
Take out
My
basis
was very low,
so things turned
$10 price return of 27%
$30
Cisco,
business
modelare
survived
tech of
fine
in whose
the long
run.” There
many the
examples
$0 annually vs. market
$20
returns 1994
of 8%
1990
1998
2002
2006
2010
2014
collapse.
It suffered
a hugeinprice
decline from
this
paradigm,
particularly
Technology.
Takeits
$10
Source: Bloomberg, J.P. Morgan Asset Management. July 2014.
peak and
has business
only recaptured
a small amount
Cisco,
whose
model survived
the techsince
$0
then, but It
still
generated
substantial
excessfrom
returns
collapse.
suffered
a huge
price decline
its
1990
1994
1998
2002
2006
2010
2014
vs. theand
market
overrecaptured
the long run
for its original
concentrated
holders.
That’s
the Asset
purpose
of theJuly
second
peak
has only
a portion
since then,
Source:
Bloomberg,
J.P. Morgan
Management.
2014.
step:still
life-cycle
analyses
of stock
pricereturns
returns,vs.
tothe
look for stocks whose returns were positive over the
but
generated
substantial
excess
long runover
despite
interim
and volatility.
The negative
ofthe
thepurpose
distribution
onsecond
the prior
market
the long
runcollapses
for its original
concentrated
holders. skew
That’s
of the
step:
page shows
that while
some
stockstogenerated
volatile
but positive
returns
(like
many
life-cycle
analyses
of price
returns,
look for stocks
whose
returnslife-cycle
were positive
over
theCisco),
long run
more did
not. collapses and volatility. The negative skew of the distribution on the prior page shows
despite
interim
that while some stocks generated volatile but positive life-cycle returns (like Cisco), many more did not.
The frequency of catastrophic declines and the negative skew in the distribution of
individual
stockofreturns
compound
our and
perception
of concentrated
risk, andof
suggest
The
frequency
catastrophic
declines
the negative
skew in thestock
distribution
individual
stock returns
ourrole
perception
ofplanning
concentrated
stock
risk, and suggest
that diversification
play compound
an important
in wealth
for most
entrepreneurs.
that diversification play an important role in wealth planning for most entrepreneurs.
2
In the case of Utilities, the frequency of negative absolute returns is very low, while the frequency of negative
excess returns is high. This is a reflection of the lower returns on utility stocks, which are offset by their much
2lower catastrophic loss rate. While utility stock risk is lower than the market, there have been more than a few
In the case of Utilities, the frequency of negative absolute returns is very low, while the frequency of negative
examples
of extreme
as explained
in thereturns
case study
section.
excess
returns
is high.utility
This distress,
is a reflection
of the lower
on utility
stocks, which are offset by their much
lower catastrophic loss rates. While utility stock risk is lower than the market, there have been more than a few
examples of extreme utility distress, as explained in the case study section.
7
7
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on
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E
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P . MMorgan
ORGAN
Why volatility matters and its implications for “optimal” concentrated holdings
Annualized stock price return
To many clients, stock price changes over the long run are all that matter, rather than anything that
happens in between. However, volatility can be an important signal since it tells us something about
the risk of a stock. Not everyone agrees that interim price movements are a good proxy for “risk”; in
some cases, they aren’t. However, over the long run, returns and volatilities tend to track each
other pretty closely. For purposes of this
Higher volatility usually associated with lower stock
analysis, we define risk as “volatility of
price returns, Universe: Russell 3000 stocks, min. 3 years of
negative stock price movements”; in other
returns, 1980-2014
words, we look at volatility from falling stock
200%
prices rather than from falling and rising ones.
150%
I find that most investors prefer this definition
100%
of risk (technically referred to as semideviation), since they are not worried about
50%
the risk of rising prices. As shown, if the
0%
volatility of your stock is rising sharply,
-50%
chances are that its returns are falling.
-100%
Next, we factor risk into the equation of
0%
20%
40%
60%
80%
100%
120%
140%
being a concentrated stockholder. With 20Downside volatility (semi-deviation)
20 hindsight, we can compute the “optimal”
Source: FactSet, J.P. Morgan Asset Management.
combination of any stock with the Russell
3000. In other words, what combination of each stock and the Russell 3000 would have
delivered the best risk-adjusted return? Such an approach did not always hold a lot of a highreturning stock if its volatility was too high. Similarly, it held more of a lower-returning stock if it
exhibited attractive diversification benefits vs. the Russell 3000. The results tell us something about the
frequency with which concentrated holders would optimally choose to own different amounts of their
stock, if the issue of price volatility mattered to them.
The bar chart below shows the results. There were quite a few cases when the optimal course of action
from a risk-adjusted perspective was to own 100% in the concentrated stock: that happened around
6% of the time (500 observations in our data set). However, in the majority of cases, it made sense to
own no more than 30% of the concentrated stock, and often none of it. This is not a surprise; as per
page 6, if two-thirds of stocks underperformed the Russell 3000, it is very unlikely that a risk-adjusted
approach would want to own many of them since it would prefer to own the Russell 3000 instead.
Optimal mix of a concentrated stock position with the
Russell 3000, 1980-2014, number of observations
3,500
3,000
2,500
2,000
1,500
1,000
500
0
0%
10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Optimal concentrated stock weight
Source: FactSet, J.P. Morgan Asset Management.
8
8
Eye on the Market

J.P. MORGAN
Eye on the market • J.P. Morgan
As a last step in our empirical analysis, we weave together each of the three risk factors we
have examined so far: the risk of catastrophic loss, the risk of underperforming the Russell
3000 and finally, the risk of heightened volatility that subjected concentrated holders with
insufficient diversification to a very wild ride.
In the table below, we show the percentage of stocks in each sector that:
•
•
•
•
suffered a catastrophic loss; or
generated negative absolute lifetime returns; or
generated negative excess lifetime returns vs. the Russell 3000; or
experienced high volatility such that the optimal portfolio process described on the prior page
chose to own no more than 20% in the stock.
In other words, all the cases in which some amount of diversification would have made sense. With
the benefit of hindsight, in around three-quarters of all cases, diversification could have played an
important role in sustaining family wealth.
Percent of stocks whose concentrated holders
would have benefited from diversification, 1980-2014
Sector
Percent
All sectors
74%
74%
Consumer Discretionary
Consumer Staples
58%
Energy
81%
Materials
75%
Industrials
75%
Health Care
72%
Financials
63%
Information Technology
82%
Telecommunication Services
74%
Utilities
87%
Source: FactSet, J.P. Morgan Asset Management.
9
9
Eye on the Market

J.P. MORGAN
Eye
on
market
 •
Sector
study
E
ye o
n case
tthe
he M
a r k e tforensics
J . J.P.
P . MMorgan
ORGAN
A
deeper
divestudies:
into catastrophic
stock price
loss reveals important
realities of global business dynamics.
Sector
case
some forensics
on catastrophic
loss
There are hundreds of cases to choose from; the ones selected illustrate different paradigms and
factors
affecting
stocks
that suffered
and permanent
We focus
on large
cap
A deeper
dive into
catastrophic
stock substantial
price loss reveals
importantimpairment.
realities of global
business
dynamics.
(and the
end of mid
since many
“household
names”
at thedifferent
peak of paradigms
their success.
There
areupper
hundreds
casescap),
to choose
from;were
the ones
we selected
illustrate
thatIt is
not always
simple to explain
why a company
suffered
a focus
decline,
combination
of fundamental
resulted
in substantial
and permanent
impairment.
We
onsince
largeacap
(and the upper
end of mid
factors
and
the
whims
of
investor
sentiment
are
involved.
The
descriptions
represent
oursimple
perception
cap), since many were “household names” at the peak of their success. It is not always
to of
the primary
other
explanations
maysince
be just
as plausible. ofNote
that thesefactors
examples
chosen
explain
why factors;
a company
suffered
a decline,
a combination
fundamental
andwere
the whims
in the
summer
of 2014;
time, many
“Lazarus” stocks
come
from theofdead,
so it is fair
to
of
investor
sentiment
areover
involved.
The descriptions
represent
ourback
perception
the primary
factors;
assume
that some of
them
mayasrecover
fromNote
theirthat
current
levels.
other
explanations
may
be just
plausible.
these
examples were chosen in the summer of
2014;
over studies,
time, many
“Lazarus”
stocksofcome
back over-expansion,
from the dead, so
it is fair totowards
assumethe
thatend
some
In
the case
there
are instances
leveraged
particularly
of aof
them
may
recover
from
their
current
levels.
business cycle, and examples of management misreading rapidly-changing industry dynamics and
competitive
factors.there
There
were
also examples
of companies
that mismanaged
large acquisition;
In
the case studies,
are
instances
of leveraged
over-expansion,
particularly atowards
the end ofwe
a
were
not
surprised
to
find
these
instances,
since
most
studies
we
have
seen
estimate
M&A
failure
business cycle, and examples of management misreading rapidly-changing industry dynamics
and rates
3
at
50% to 80%
of allThere
transactions
However,ofmany
of the companies
suffereda due
factors largely
competitive
factors.
are also.examples
companies
that mismanaged
largetoacquisition;
we
outside
control.
some of
factors
the box
on the
facing
were notmanagement’s
surprised by this,
since We
mostliststudies
wethese
have exogenous
seen estimate
M&Ainfailure
rates
at 50%
to 80%
3
page.
After reviewing
the companies
affected suffered
by them,due
it isto
not
clear that
evenoutside
the bestmanagement
management
of all transactions
. However,
many companies
factors
largely
teams
in
the
world
could
have
done
much
to
alter
the
ultimate
outcome.
control. We list some of these exogenous factors in the box on the facing page. In these cases, it is
not clear
that catastrophic
even the best losses
management
in thepages
world may
couldseem
have obvious
done much
alter the with
While
some
on the teams
following
or to
inevitable
ultimate
outcome.
the benefit of perfect hindsight, in all likelihood the company’s management, its board of
directors,
research
analysts,
credit
agenciespages
and its
employees
all firmly
believed in
its
While
some
catastrophic
losses
on rating
the following
may
seem obvious
or inevitable
with
long-term
the benefitsuccess.
of perfect hindsight, in all likelihood the company’s management, its board of
directors, research analysts, credit rating agencies and its employees all firmly believed in its
Notes
aboutsuccess.
the charts
long-term
Some examples show pre-Chapter 11 prices of companies that have since emerged from bankruptcy
and
areabout
now the
thriving
with sound operating businesses (e.g., Charter Communications and Calpine), in
Notes
charts
which
case
the
primary
problem was
prior that
capital
structure.
All stocks
arebankruptcy
shown
Some examples show pre-Chapter
11often
pricesthe
of firm’s
companies
have
since emerged
from
through
their
final
reported
pricing
date,
which
is
either
July
31,
2014,
or
an
earlier
date
when
the are
and are now thriving operating businesses (e.g., Charter Communications and Calpine). All stocks
company
was
acquired,
merged
or
delisted
and
which
is
noted
below
the
chart.
Price
histories
shown through their final reported pricing date, which is either July 31, 2014, or an earlier dateon
when
many
stocks reflect
split adjustments
that
took place
over time,
suchbelow
that historical
lower
the
company
was acquired,
merged or
delisted
and which
is noted
the chart.prices
Priceappear
histories
on
than the
levels
at which
were once
many
stocks
reflect
split they
adjustments
thatquoted.
took place over time, such that historical prices appear lower
than the levels at which they were once quoted.
3
The earliest analyses performed in the US and Europe in the 1970’s found merger and acquisition failure rates
of 40%-50%. More recent estimates are higher. Wharton’s “Why Do So Many Mergers Fail” cites professor
3
Robert
Holthausen,
whose
failureinrate
range from
A 2010
study
McKinsey
estimates
The earliest
analyses
performed
theestimates
US and Europe
in the50%-80%.
1970’s found
merger
andfrom
acquisition
failure
rates
failure
rates
of
66%-75%.
And
in
a
2010
book
from
Mitchell
Lee
Marks
(San
Francisco
State
University,
and an
of 40%-50%. More recent estimates are higher. Wharton’s “Why Do So Many Mergers Fail” cites professor
advisor
in 100 mergers
andfailure
business
failurefrom
rates50%-80%.
are estimated
at 75%.
Robert Holthausen,
whose
ratetransitions),
estimates range
A 2010
study from McKinsey estimates
failure rates of 66%-75%. And in a 2010 book from Mitchell Lee Marks (San Francisco State University, and an
10
advisor in 100 mergers and business transitions), failure rates are estimated at 75%.
10
10
Eye on the Market

J.P. MORGAN
Eye on the market • J.P. Morgan
Force Majeure: a partial list of exogenous factors that can put companies at risk and
which are outside management control
•
commodity price risks that cannot be hedged away
•
government policy examples: changes in service reimbursement rates, a slowdown in FDA
approval patterns, bandwidth and other public domain privatizations which increase the scope
of competition, changing subsidies for renewable energy, changes in carbon tax regimes and
fracking rules, government-sponsored enterprises with a lower cost of funds crowding out
private sector activity, changes in the interpretation of anti-trust rules, shifts from capacity
pricing to merchant pricing (natural gas), etc.
 on government action, deregulation has proven to be just as disruptive as re-regulation,
particularly as it relates to boom–bust cycles in telecommunications, utilities and brokerdealers
•
foreign competitors whose market share is magnified by government subsidies and
exchange rate manipulation
 China’s exchange rate management and subsidies to its auto, steel, solar, paper and glass
companies are primary examples (see Appendix I for more details)
•
intellectual property infringement by domestic or foreign firms (see Appendix I)
•
the impact of patent trolls, estimated to cost US businesses upwards of $20 billion per year
•
changes in US or foreign government tariff or trade policy
•
fraud by non-executive employees, which according to SEC investigations from 1997-2007
accounted for ~30% of all instances; or fraud by employees or management in companies that
you acquire, or which acquire you
•
technological innovation that effectively provides consumers with enough information to
bypass intermediaries and distributors
•
a shift in buying power to the firms’ customers resulting from consolidation
•
unconstrained expansion by competitors, leading to a collapse in pricing power
11
11
Eye
on
market
E
ye o
n tthe
he M
a r k e t  •J . J.P.
P . MMorgan
ORGAN
Consumer Discretionary
Consumer Discretionary has seen its fair share of catastrophic declines (see list on following page). Big
box multi-line retailing, online retailers, auto parts, print media, publishers, music, faddish apparel and
restaurant chains make up most of the list. One factor perhaps underappreciated by concentrated
holders: according to Nielsen surveys, US consumers are less brand-loyal than their counterparts
in Europe, Asia, the Middle East and Latin America when it comes to mobile phones, personal
electronics, electronic appliances, beauty products, health/medical products, in-store retail and
cable/internet service. They’re also more likely to switch brands for a better price. Many brands
enjoyed success during their initial expansion phase, but faced challenges when organic new store
growth slowed, and when consumer tastes changed. Radio, music and print media struggled with
shifting technology, which put a lot of pressure on ad revenues (e.g., a 57% drop in newspaper ad
revenue from 2000 to 2009).
Once the pioneer of discount retailing, management
outflanked by Walmart and Target, and underinvested
in merchandise, key locations and supply chain
Overleveraged cable television acquisition spree paid
for with inflated stock price; accounting issues
$25
$30
Kmart Corporation
$25
$20
$20
$15
Charter Communications
$15
$10
$10
$5
$5
$0
1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003
$0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source: Bloomberg. May 2003.
Source: Bloomberg. November 2009.
Surpassed by digital competitors; low barriers of entry
Bad timing: leveraged theme park acquisitions heading
into a recession
$90
$80
$70
$40
Weight Watchers International Inc.
$35
$60
$30
$50
$25
$40
$20
$30
$15
$20
$10
$10
$5
$0
2002
2004
2006
2008
2010
2012
2014
$0
1996
Premier Parks Inc. (Six Flags)
1998
2000
2002
2004
2006
2008
Scorched earth strategy works too well: fending off The
Limited (via spinoff of Neiman Marcus and massive debt)
doomed the company's future
Organic sales growth hits a wall at 2,000 stores,
acquisition of a key but fading rival compounds the
problem
$180
$35
$160
$30
$140
Carter Hawley Hale
Stores (Broadway Stores)
$120
$100
$25
Sunglass Hut International Inc.
$20
$80
$15
$60
$10
$40
$5
$20
$0
1988
2010
Source: Bloomberg. May 2010.
Source: Bloomberg. July 2014.
1989
1990
1991
Source: Bloomberg. October 1995.
1992
1993
1994
1995
$0
1994
1995
1996
1997
1998
1999
2000
2001
Source: Bloomberg. April 2001.
12
12
Eye on the Market

J.P. MORGAN
Eye on the market • J.P. Morgan
There are dozens of other cases we could have chosen to illustrate examples of distress in the
Consumer Discretionary sector. The table below shows some of the more recognizable names. Some
date back to the 1980’s, while others are more recent.
Select Consumer Discretionary stocks in the Russell 3000 suffering unrecovered, catastrophic
losses (see page 4 for definition) by industry, 1980 to 2014
Auto Components
Dana Corp.
Delphi Corporation
Federal-Mogul Corp.
Goodyear Tire & Rubber Company
Lear Corporation
Visteon Corp.
Department Stores
Federated Department Stores Inc.
Macy's, Inc.
Distributors
GNC Energy Corp.
Subaru of America Inc.
Diversified Consumer Services
Apollo Education Group Inc.
Corinthian Colleges Inc.
Education Holdings 1 Inc.
ITT Educational Services Inc.
Learning Tree International Inc.
Hotels Restaurants & Leisure
Bally Total Fitness Holding Corp.
Boston Chicken, Inc.
Boyd Gaming Corporation
Checkers Drive-In Restaurants, Inc.
Chi-Chi's Inc.
Churchs Fried Chicken, Inc.
Coleco Industries, Inc.
Cosi, Inc.
Krispy Kreme Doughnuts, Inc.
Luby's, Inc.
Monaco Coach Corporation
Morton's Restaurant Group Inc.
Patriot American Hospitality Inc.
Rainforest Cafe, Inc.
Shoney's Inc.
Sizzler Restaurants International Inc.
TCBY Enterprises, Inc.
Trump Hotels & Casino Resorts, Inc.
Household Durables
Centex Corp.
Hovnanian Enterprises, Inc.
Household Durables (continued)
Kaufman & Broad Home Corp.
Maytag Corporation
Pillowtex Corp.
Sealy Corp.
Standard Pacific Corp.
Sunbeam Corporation
Zenith Electronics Corporation
Internet & Catalog Retail
barnesandnoble.com inc.
Buy.com Inc.
Drugstore.Com Inc.
eToys, Inc.
Home Shopping Network, Inc.
Lillian Vernon Corporation
Nutrisystem, Inc.
Spiegel Inc.
Webvan Group, Inc.
Leisure Products
Baldwin Piano & Organ Company
Callaway Golf Company
LeapFrog Enterprises, Inc.
Polaroid Corporation
Worlds of Wonder, Inc.
Media
Adelphia Communications Corporation
Cablevision Systems Corporation
Carolco Pictures Inc.
Clear Channel Outdoor Holdings Inc.
Crown Media Holdings Inc.
Emmis Communications Corporation
Gannett Co., Inc.
Harcourt Brace Jovanovich Inc.
Harte-Hanks Inc.
Idearc Inc.
Intelsat Corporation
Interpublic Group of Companies, Inc.
Loews Cineplex Entertainment Corp.
Martha Stewart Living Omnimedia, Inc.
McClatchy Company
New York Times Company
Orion Pictures Corporation
Readers Digest Association Inc.
Media (continued)
RH Donnelly Corp.
Savoy Pictures Entertainment, Inc.
Warner Music Group Corp.
Westwood One Inc.
XM Satellite Radio Holdings
Multiline Retail
Ames Department Stores Inc.
Bradlees Discount Store Inc.
Caldor Corp.
Circle K Corp.
Filene's Basement Corp.
J. C. Penney Company, Inc.
Specialty Retail
Aeropostale, Inc.
bebe stores, Inc.
Blockbuster Inc.
Boise Cascade Corporation
Borders Group Inc.
Chico's FAS, Inc.
Circuit City Stores, Inc.
Coldwater Creek Inc.
CompUSA Inc.
Design Within Reach, Inc.
Eddie Bauer Holdings Inc.
FAO Schwarz, Inc.
Heileg-Myers Furniture Co.
Jennifer Convertibles Inc.
Just For Feet, Inc.
Lechter's Inc.
Office Depot, Inc.
RadioShack Corp.
Restoration Hardware Inc.
Sharper Image Corp.
Talbots Inc.
Today's Man Inc.
Textiles Apparel & Luxury Goods
Burlington Industries Inc.
Crocs, Inc.
Fruit of the Loom Ltd.
Jones Apparel Group Inc.
L.A. Gear, Inc.
North Face, Inc.
13
13
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market
Morgan
E y e on
o n the
the M
a r k e t  •J .J.P.
P. M
ORGAN
Consumer Staples
As noted on page 5, Consumer Staples have a lower rate of catastrophic price decline than the market
as a whole. The Staples that did suffer such declines were often low-margin supermarket, drug store
and convenience store chains that struggled to compete with the rise of Walmart (Bruno’s, Drug
Emporium, Food Lion, A&P, SuperValu, Pantry Inc. and Winn-Dixie); we only review one of them below
since the narratives are similar. According to a 2009 study from Dartmouth, when a Walmart opens in
a new market, median sales drop 40% at similar high-volume stores, 17% at supermarkets and 6% at
drug stores. There are some other episodes worth discussing, which we review as well. The first one
below refers to the 15-year US-European banana war, an illustrative example of risks around trade and
tariffs. Eventually, Europe reached a deal under which it planned to provide equal treatment to all
importers. Unfortunately, this came too late for companies like Chiquita Brands.
Chiquita expanded during trade talks to open European
banana market, suffers when Europe opts to maintain
imports from former colonies; 2001 Chapter 11 filing
$60
Competition in low-margin supermarkets from Walmart
and Publix too much for “America’s Supermarket”
$60
$50
United Brands Company (Chiquita)
$50
$40
$40
Winn-Dixie Stores Inc.
$30
$30
$20
$20
$10
$10
$0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
$0
1981
Source: FactSet. March 2002.
Source: Bloomberg. November 2006.
Sometimes there’s no room for #3 (behind Duracell and
Energizer); non-core acquisitions (pet supply) outside
company core competence
1984
1987
1990
1993
1996
1999
2002
2005
Over-leveraged Revlon runs into deep-pocketed
competitors (J&J, P&G), and loses
$500
$45
$40
$35
$30
$400
Rayovac Corporation
$300
$25
Revlon Inc.
$20
$200
$15
$10
$100
$5
$0
1998
2000
2002
2004
2006
2008
$0
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Source: Bloomberg. July 2014.
Source: Bloomberg. August 2009.
Doing business in China involves under-regulated supply
chains and the lack of consumer safeguards
$50
Chapter 22? Hostess first went bankrupt in 2004, citing
reduced demand for high-carb snacks and rising
labor/energy costs
$40
$40
Synutra International Inc.
$30
$30
$20
$20
$10
$10
$0
2006
2007
2008
2009
Source: Bloomberg. July 2014.
2010
2011
2012
2013
2014
$0
1992
Hostess Brands
(Interstate Bakeries)
1994
1996
1998
2000
2002
2004
2006
2008
Source: Bloomberg. February 2009.
14
14
Eye on the Market

Eye on the market • J.P. Morgan
J.P. MORGAN
Energy
Energy rivals Technology as the sector most ideally suited to discussions about concentration risk. The
nature of exploration and production, commodity prices, business cycle risks, environmental accident
risks and regulatory issues create a volatile backdrop for many oil and gas stocks. Event risk in E&P
spiked during the oil price decline in the early 1980’s, and almost every time since when a commodity
price falls unexpectedly, such as during the natural gas price decline of 2009. Energy stock price
volatility is not just an issue for E&P: out of 27 S&P 500 industries with at least 8 stocks, Energy
Equipment & Services exhibited the highest volatility from 2002 to 2012, even higher than Metals &
Mining, Software and Semiconductors (recent equipment/services catastrophic loss examples include
McDermott, Willbros and Hercules). Business risk in the Energy sector is not confined to oil/gas and
related services: despite the world’s voracious use of coal (up 50% since 2000, with 2013 as the
highest year of global coal consumption as a % of primary energy since 1970), coal companies face
plenty of challenges as well.
Texas-based natural gas company suffers from
collapse in natural gas prices, and leverage (45% of
revenue in Q1 2014 used to pay interest expense)
Largest coal company in the world; global expansion
designed to reduce impact of US regulations and nat
gas boom ended up damaging margins
$45
$100
$80
$60
Peabody Energy Corporation
$40
Similar stock price declines:
Arch Coal, Alpha Natural
Resources, Consol, James
River, Patriot Coal
$35
$30
$25
$20
$40
Quicksilver Resources Inc.
Similar stock price
declines: Chesapeake,
SandRidge, Comstock,
Exco, Ultra Petroleum,
Penn Virginia
$15
$10
$20
$5
$0
2002
2004
2006
2008
2010
2012
2014
$0
2000
When core competence is in shallow water, deepwater
operations can be high risk for companies providing
construction equipment and services
2004
2006
2008
2010
2012
2014
Owners of Deepwater Horizon, the semisubmersible
drilling rig which caught fire, exploded and then sank in
the Gulf of Mexico
$35
$175
$30
$150
$25
$125
McDermott International Inc.
$20
2002
Source: Bloomberg. July 2014.
Source: Bloomberg. July 2014.
Transocean
$100
$15
$75
$10
$50
$5
$25
$0
1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013
$0
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Source: Bloomberg. July 2014.
Source: Bloomberg. July 2014.
Early 1980's: OPEC over-supply and lower oil demand
due to recession hurts E&P and equipment/servicers
What happens to the largest operator of oil tankers
when tanker rates decline by 40%-50%; leverage and
some aging vessels compound the problem
$3,500
$80
Western Company of North America
$3,000
$70
Similar stock price declines:
Dome Petroleum, Edisto Resources,
Southland Royalty, Apache, Parker Drilling
$2,500
$60
$50
$2,000
$40
$1,500
$30
$1,000
$20
$500
$10
$0
1980
Frontline Ltd.
1981
1982
1983
Source: FactSet. March 1989.
1984
1985
1986
1987
1988
1989
$0
2000
2002
2004
2006
2008
2010
2012
2014
Source: Bloomberg. July 2014.
15
15
Eye
E y eon
o nthe
t h e market
M a r k e t • JJ.P.
. P . Morgan
MORGAN
Financials
There’s a long list of banks, brokerage firms, mortgage insurers, REITs and specialty finance companies
that suffered permanent price declines during the financial crisis of 2008-2009. What’s interesting for
purposes of understanding concentration risk in Financials: the role that government policy can
play in altering or influencing the behavior of private sector firms. As described in a November
2013 Eye on the Market (“Course of Empire”), US government-sponsored enterprises took a lot of the
oxygen out of the room: the green and red lines in the chart show the increase in high-risk lending
undertaken by the GSEs which predated the massive increase in subprime and Alt A lending by the
private sector (black line). The GSE increases move roughly in tandem with lending standards which
required the GSEs to make more low and moderate income loans (blue line). This timeline is not meant
to absolve the private sector, which made some horrendous and well-documented underwriting
decisions; the point is to understand what government actions and policies preceded them.
The Course of Empire: Prelude to Destruction
Percent of annual underwriting (except Fannie/Freddie share based on total outstanding balances)
60%
55%
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
Fannie/Freddie share of GSE
+ Private sector
FHA LTV
>=97%
Freddie Mac/Fannie
Mae underwriting
that exceeded
traditional standards
in selectively
disclosed portfolio
1
2
GSE Low & Moderate
Income lending target
3
4
5
1. Non-traditional Freddie Mac
2. Freddie cash out CLTV > 75%
3. Fannie/Freddie DTI > 38%
4. Fannie purchase loan CLTV > 90%
5. Fannie/Freddie DTI >= 42%
Private sector subprime and Alt A % of
total origination
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source: American Enterprise Institute. J.P. Morgan Asset Management. November 2013.
A brief summary of the timeline (see November 18, 2013 Eye on the Market for more details)
In 1990, Fannie Mae and Freddie Mac (government-sponsored enterprises) adhered to prudent underwriting on
single family mortgages: the vast majority had debt-to-income ratios below 38%, loan-to-values below 90% on
purchase loans, or loan-to-values on cash-out refinancing loans below 75%. The GSEs had a one-third share of
outstanding mortgages. Private sector subprime had existed for decades, but was limited in size at ~10% of
annual residential mortgage origination. Home ownership rates and home prices relative to income and
replacement cost were stable at post-war averages.
The era of sound GSE lending did not last. The 1992 “Federal Housing Enterprises Financial Safety and
Soundness Act” enabled the Department of Housing and Urban Development to set formalized minimum
affordable lending standards for the GSEs. HUD first set Low & Moderate Income standards at 30% of annual
GSE acquisitions, and raised them to 50% in the week before the November 2000 election. Home ownership
rates jumped, and home prices relative to replacement cost, rent and household income began to rise above
historically stable levels.
By 2002, the GSEs had increased their market share from one-third to 60% as the size of the mortgage market
rose by 2.5x vs. 1990. Freddie Mac’s non-traditional loans were ~45% of their annual acquisitions and
guarantees, and more than 40% of Fannie Mae’s Alt A (low documentation) loans qualified for the HUDdetermined affordable housing goals. Note that the GSE revolution took place before the explosion in private
sector subprime and Alt A loans.
In 2003, the private sector found a way to compete: the deepening of private mortgage backed securities
markets. Home prices surged further, and the mortgage market doubled in size vs. 2002. The private sector
regained market share, mostly through subprime and Alt A loans which rose to 40% of annual origination. To
be clear, private sector defaults and losses per dollar on subprime were much worse than on GSE loans,
particularly when related to malignant derivative offshoots.
16
16
Eye on the Market

Eye on the market • J.P. Morgan
J.P. MORGAN
Another large part of the financial crisis
Growth in assets and major financial sector legislation
Index, 12/31/1992 = 100
resulted from under-capitalized risk-taking
1,000
at the 5 large broker-dealers. As background,
Broker-dealers $4.2 Trillion
900
in the mid 1970’s, broker-dealers like Merrill
5 institutions
800
Lynch, DLJ and A.G. Edwards were leveraged
SEC Uniform Net
700
Capital Rule Change
from 5-to-1 to 8-to-1. Most of their activities
600
were “brokering” (acting as agent), not
500
Gramm-Leach“dealing” (acting as principal). Commission
400
$10 Trillion
Bliley Act
deregulation then reduced their core profitability
513 institutions
300
(commissions declined from 61% of industry
200
Commercial banks
revenues in 1965, to 40% in 1976, to 16% in
100
>$1billion in assets
1990), leading many firms to push for ways to
0
Dec-92 Dec-95 Dec-98 Dec-01 Dec-04 Dec-07
take on higher leverage and higher risk. In 2004,
Source: FDIC, Bloomberg.
the SEC eliminated the Net Capital Rule that had
limited broker-dealer leverage at 12-1 since
1975. As shown in the chart, broker-dealer balance sheets soared after this took place. By 2006,
broker-dealers were leveraged around 30/35-1, with the 5 largest balance sheets comprising $4.2
trillion in assets, and the rest is history.
In terms of what has happened since, the chart below shows the degree to which stock prices of the
largest S&P 500 banks and capital markets firms recovered relative to June 2007 levels. Surviving firms
are now adhering to stricter capital standards not only via higher minimum requirements, but also in
improved quality of capital (more reliance on loss-bearing capital like tangible common equity and the
exclusion of trust preferreds from Tier 1 capital altogether). Furthermore, US banks have made a
substantial transition away from wholesale (interbank) liquidity, which has fallen from 47% to 27% of
all funding. All things being equal, these steps should reduce event risk in the financial system.
However, banks are still highly exposed to the business cycle, credit losses and changes in monetary
policy; substantial risks of concentrated ownership remain.
S&P 500 Banks, Brokers and Consumer Finance firms: changes in stock price vs. June 2007
Current index level, 6/30/2007=100
150
140
Higher than June 2007 stock price
Below June 2007 stock price
Delisted or acquired*
130
120
110
100
90
80
70
60
50
40
30
20
10
WaMu
Lehman
CIT Group
National City
Bear Stearns
Citigroup
E*TRADE
Wachovia
Countrywide
Merrill Lynch
Synovus
Marshall & Ilsley
Regions
Bank of America
First Horizon
Zions Bancorp
KeyCorp
SLM Corp
SunTrust
Huntington
Morgan Stanley
Fifth Third Bank
Comerica
Goldman Sachs
BB&T Corp
Commerce Banc.
Capital One
M&T Bank
PNC Financial
US Bancorp
JPMorgan Chase
Schwab
Amer. Express
Wells Fargo
0
Source: Bloomberg. J.P. Morgan Asset Management. July 31, 2014. *Delisted or acquired stocks shown as of last reported price bef ore delisting or acquisition.
17
17
Eye
on
market
J.P.
E
ye o
n tthe
he M
a r k e t  •J . P
. MMorgan
ORGAN
As for Financial concentration risk before 2008, there was a spike in distress in banks and thrifts during
the consumer-led recession of the late 1980’s. What’s more interesting as part of a discussion on
concentration risk are the Financial sector business models that are presumably more stable: insurance
companies, companies acting as fee-based transaction agents, REITS and asset managers. History
provides quite a few examples of how overly aggressive insurance companies, without access to the
Fed’s Discount Window, can experience substantial distress when the business cycle turns. While many
financial institutions have made substantial changes to their approach to leverage since the credit crisis,
REIT capital structures look pretty similar, with most leveraging via bond markets instead of through
syndicated bank loans. As a result (and given their cash flow distribution requirements), equity and
mortgage REITs implicitly assume that credit and equity markets will remain open, even during a
recession. The REIT stresses during 2008-2009 were in some ways the first big test for the sector, since
they were much less prevalent during the prior commercial real estate recession in 1990-1991.
There are a million flavors of derivatives, and some of
them taste terrible
$1,750
$60
$1,500
$1,250
$1,000
Sometimes short-sellers are right: a leveraged,
acquisition-based insurance company makes little
sense, and became the 3rd largest bankruptcy in history
$50
American International
Group, Inc.
$750
$30
$500
$20
$250
$10
$0
1987
$0
1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013
An overly aggressive investment strategy (i.e., 45% of
Executive Life's assets in HY bonds) can attract
attention of regulators and scare policyholders
$20
$12
1993
1995
1997
1999
2001
2003
Diversifying a low-margin business (discount
brokerage) with a cyclical one (home equity lending)
can be hazardous to your wealth
$600
$400
E*TRADE Financial Corporation
$300
$200
$4
$100
$0
1982 1983 1984 1985
Source: FactSet. April 1991.
1986
1987
1988
1989
1990
1991
Asset managers who are concentrated by style (Janus)
or with a handful of star managers (like Legg Mason in
2006-08) can suffer radical changes of fortune
$50
$0
1997
$50
$40
$30
$10
2001
2003
2005
2007
2009
2011
2013
Most REITs came back from 2009 lows, but are still
exposed to credit crises given 90% income
distribution, no access to Fed discount window and
preference for bonds > more easily negotiable
syndicated bank loans
$60
$20
1999
Source: Bloomberg. July 2014.
$70
Janus Capital Group Inc.
$30
$0
Jun-00
1991
$500
First Executive
Corporation
$8
$40
1989
Source: Bloomberg. September 2003.
Source: Bloomberg. July 2014.
$16
Conseco Inc.
$40
$20
Developers Diversified Realty Corp.
Similar REIT declines
and recoveries: General
Growth Properties,
Duke, Maguire, Cousins
$10
Jun-02
Jun-04
Jun-06
Source: Bloomberg. July 2014.
Jun-08
Jun-10
Jun-12
Jun-14
$0
1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013
Source: Bloomberg. July 2014.
18
18
Eye on the Market

Eye on the market • J.P. Morgan
J.P. MORGAN
Health Care
Health Care includes pharmaceutical companies, biotech, medical devices, hospitals and assorted
service providers. As you might expect, relative business risks differ. On large-cap pharma, generic
drugs took their toll: from 2003 to 2012, generic drug consumption generated $1.2 trillion in savings
for the US health care system, much of which represented lost revenue for branded pharmaceutical
companies. The highest event risk in the sector is of course related to Biotechnology. According to
Harvard’s Gary Pisano, even when a drug finally gets to Phase 3 trials, the probability of failure can still
be as high as 50%. Pisano also found that the R&D process at biotech firms has been no better than at
big pharma companies; a study in the Journal of Health Economics actually found that larger firms had
better performance in drug discovery. One irony about the biotech boom-bust of 2000: part of it was
based on the promise of mapping the human genome, which is now finally paying dividends (timing is
everything). While 2000-2001 was the peak in biotech distress, there have been over 100 catastrophic
failures of Russell 3000 biotech/life sciences companies since 2002 (see Appendix II).
Device companies heavily reliant on one product (drugcoated stents, in this case) are like concentrated stock
portfolios themselves
$50
$45
Boston Scientific
$40
Corporation
$35
$30
$25
$20
$15
$10
$5
$0
1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013
Note to CEOs selling a company for stock in a roll-up:
due diligence on buyers is important; largest outpatient
rehab roll-up was fueled in part by accounting fraud
$160
$140
HealthSouth
Corporation
$120
$100
$80
$60
$40
$20
$0
1987
1990
1993
1996
1999
2002
2005
2008
2011
2014
Source: Bloomberg. July 2014.
Source: Bloomberg. July 2014.
Prostate cancer wonder drug? Sometimes FDA
approval is not enough, customer demand has to
materialize as well
Unanticipated sharp declines in Medicare reimbursements
render GHV (nursing home) capital structure inoperable;
contagion spreads to other providers
$40
$60
Company
withdrew
guidance
Dendreon Corporation
$50
FDA approval
received
$40
$20
$30
$25
Successful
test results
announced
$30
Genesis Health
Ventures Inc.
$35
$20
$15
$10
$10
$5
$0
Jun-00 Jun-02 Jun-04 Jun-06 Jun-08 Jun-10 Jun-12 Jun-14
$0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Source: Bloomberg. July 2014.
Source: Bloomberg. October 2001.
FDA approval tolerance can shift over time, particularly if
approved competitors (Lunesta, Ambien) show signs of
negative side effects
Advanced scientific breakthroughs (even mapping
human DNA sequences) do not necessarily translate
immediately into profitable business models
$70
$60
$120
Neurocrine
Biosciences, Inc.
FDA denies
approval for
larger dose
Indiplon
insomnia drug
$50
$40
$30
Largest Biotech companies with
catastrophic price declines, 2000-02:
Millennium, Celera, Abgenix, Protein
Design Labs, Medarex, Maxygen,
Curagen, Enzon, Cell Therapeutics
$80
$60
$40
$20
$20
$10
$0
1997
Human Genome Sciences Inc.
$100
1999
2001
2003
Source: Bloomberg. July 2014.
2005
2007
2009
2011
2013
$0
1996
1998
2000
2002
2004
2006
2008
2010
2012
Source: Bloomberg. August 2012.
19
19
Eye
on
market
E
ye o
n tthe
he M
a r k e t  •J . J.P.
P . MMorgan
ORGAN
Industrials
Most Industrial failures that people remember are airlines, which is understandable since there have
been so many (162 airline bankruptcies from 1978 to 2005 as per the US GAO). There have been
other Industrial distress cases as well. Many thrived for a long period of time, sometimes multiple
decades, perhaps convincing concentrated holders that event risk was minimal. Then, something
changed: Asian growth, asbestos litigation, competitive forces resulting from China’s entry into the
World Trade Organization, declining demand for postage equipment in the internet era (Pitney Bowes),
an unfavorable ruling by the Nuclear Regulatory Commission regarding the use of decommissioning
funds (EnergySolutions), a state government terminating alternative energy subsidies (Foster Wheeler),
etc. Regarding the latter company, there’s a broader paradigm of business risk for industrial companies
involved with the various aspects of renewable energy (photovoltaic equipment, wind turbines, fuel
cells and related services). See A123 Systems below, and pages 30-31 for more details.
Slow responses to low-fare competition and high salary
workers, coupled with a spike in jet fuel costs, forced
the airline to file for bankruptcy
$80
$70
$60
$50
Other catastrophic airline stock price
declines: American, Branif f , Frontier, JetBlue,
KLM, Mesa, Midway, Northwest, PanAm,
SkyWest, Texas Air, TWA, United,
US Airways, ValuJet
$40
$30
$20
Delta Air Lines Inc.
$10
$0
1981
1984
1987
1990
1993
1996
1999
2002
2005
Debt-fueled expansion and reliance on overseas
consumption can be risky: reduction in orders from
Indonesia in 1998 when its GDP fell 17%
$50
$45
$40
$35
$30
Harnischfeger Industries Inc.
$25
$20
$15
$10
$5
$0
1981 1983 1985 1987 1989 1991 1993
1995
1997
1999
Source: Bloomberg. April 2007.
Source: Bloomberg. July 2001.
In 90 AD, Pliny the Younger wrote of medical problems
associated with asbestos mining; 2,000 years later,
nearly 100 asbestos producers filed Chapter 11
Preeminent civil engineering and heavy construction
firm overextends itself financially while aggressively
expanding into non-core areas like mass transit
$60
$50
$40
2001
Owens-Corning
Fiberglass Corporation
$50
$40
$30
$30
Morrison Knudsen Corp.
$20
$20
$10
$0
1981
$10
1984
1987
1990
1993
1996
1999
2002
2005
Source: Bloomberg. October 2006.
$400
$300
1983
1985
1987
1989
1991
1993
1995
1997
Source: Bloomberg. August 1997.
One of the world's largest machine tool manufacturers
struggled to compete with cheaper foreign competition
and the slowdown in US manufacturing
$350
$0
1981
The government can sponsor the idea of electric cars,
but cannot make people buy them, or the lithium ion
batteries that A123 made
$25
Cincinnati
CincinnatiMilacron
MilacronInc.
Inc.
China
joins WTO
China joins WTO
$250
$20
$15
A123 Systems, Inc.
$200
$150
$100
$10
$5
$50
$0
1983 1986
1986 1989
1989 1992
1992 1995
1995 1998
1998 2001
2001 2004
2004 2007
2007 2010
2010
1980 1983
Source: Bloomberg. February 2013.
$0
Sep-09
Sep-10
Sep-11
Sep-12
Source: Bloomberg. July 2013.
20
20
E ye o n t h e M a r k e t
Eye on the Market


J.P. MORGAN
J.P. MORGAN
Eye on the market • J.P. Morgan
Information Technology
Information Technology
The tech sector has generated some of the most spectacular gains in the history of US equity markets.
The tech sector has generated some of the most spectacular gains in the history of US equity markets.
Google, Apple, Qualcomm, salesforce.com, eBay, Adobe Systems, Oracle, etc. are some of the most
Google, Apple, Qualcomm, salesforce.com, eBay, Adobe Systems, Oracle, etc. are some of the most
successful public companies in the world. As shown on page 7, however, only 6% of all tech
successful public companies in the world. As shown on page 7, however, only 6% of all tech
companies turned out to be extreme winners; the median tech company substantially underperformed
companies turned out to be extreme winners; the median tech company substantially underperformed
the market; 70% underperformed the Russell 3000; and over 50% generated negative absolute
the market; 70% underperformed the Russell 3000; and over 50% generated negative absolute
returns. Furthermore, almost 60% of all technology companies in the history of the Russell 3000 Index
returns. Furthermore, almost 60% of all technology companies in the history of the Russell 3000 Index
fell by 70% from their peak price and did not recover.
fell by 70% from their peak price and did not recover.
The story of the tech sector is a long narrative about disruptive technologies which are themselves
The story of the tech sector is a long narrative about disruptive technologies which are themselves
disrupted by changes that follow. Wang Labs, Silicon Graphics, Digital Equipment Corporation44 and
disrupted by changes that follow. Wang Labs, Silicon Graphics, Digital Equipment Corporation and
Commodore are some of the earlier casualties, unable to adapt to the shift away from dedicated word
Commodore are some of the earlier casualties, unable to adapt to the shift away from dedicated word
processors and 3D graphics servers and towards PC platforms based on Microsoft’s Operating System.
processors and 3D graphics servers and towards PC platforms based on Microsoft’s Operating System.
Similar fates were eventually in store for Cray Supercomputer, Prime Computer, Data General, Atari,
Similar fates were eventually in store for Cray Supercomputer, Prime Computer, Data General, Atari,
Maxtor, DEC, Borland International and other tech stalwarts of the 1980’s and 1990’s. They were all
Maxtor, DEC, Borland International and other tech stalwarts of the 1980’s and 1990’s. They were all
industry leaders at their peak, run by some of the smartest individuals in the business world whom
industry leaders at their peak, run by some of the smartest teams in the business world that would
would presumably be able to adapt to changing technologies and circumstances.
presumably adapt to changing technologies and circumstances. Most of them, however, did not.
Dedicated word processing equipment
Dedicated word processing equipment
$45
$45
$40
$40
$35
$35
Wang Labs, Inc.
$30
Wang Labs, Inc.
$30
$25
$25
$20
$20
$15
$15
$10
$10
$5
$5
$0
$0
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993
Source: FactSet. August 1993.
Source: FactSet. September 1993.
Dedicated 3D graphics servers
Dedicated 3D graphics servers
$16
$16
$14
$14
$12
$12
Silicon Graphics Inc.
Silicon Graphics Inc.
$10
$10
$8
$8
$6
$6
$4
$4
$2
$2
$0
$0
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
Source: Bloomberg. September 2006.
Source: Bloomberg. October 2006.
The next phase in the tech sector came in the late 1990’s, when internet use began to rise sharply. The
The next phase in the tech sector came in the late 1990’s, when internet use began to rise sharply. The
dot-com era was fueled by this enthusiasm, as well as by opportunities in the business-to-business
dot-com era was fueled by this enthusiasm, as well as by opportunities in the business-to-business
space. As global internet users rose ten-fold from 32 million in 1995 to 320 million by 2000, markets
space. As global internet users rose ten-fold from 32 million in 1995 to 320 million by 2000, markets
assumed that profitable business models would emerge around it. However, while global internet use
assumed that profitable business models would emerge around it. However, while global internet use
did keep growing at a rapid clip, many technology companies weren’t making enough money to
did keep growing at a rapid clip, many technology companies weren’t making enough money to
survive what turned out to be a mild recession in 2001, and required even more exponential
survive what turned out to be a mild recession in 2001, and required even more exponential internet/
internet/broadband uptake than what was occurring in order to be profitable.
broadband uptake than what was occurring in order to be profitable.
Data center provider cannot survive collapse of its tech
Data
center
provider
cannot
survive
collapse
of its
customer
base
and the
eventual
migration
from
co-tech
customer
and the
eventual migration from simple
location tobase
managed
hosting
co-location to full-service managed hosting
$80
$80
$70
$70
$60
$60
$50
$50
$40
$40
$30
$30
$20
$20
$10
$10
$0
$0
Exodus
Exodus
Communications Inc.
Communications Inc.
1998
1999
1998
1999
Source: Bloomberg. May 2002.
Source: Bloomberg. June 2002.
2000
2000
2001
2001
2002
2002
Provider of optical equipment to the high-tech food
JDS' customer base for optical equipment (Alcatel,
chain (Alcatel, Ciena, Cisco, Corning, Juniper, Lucent,
Ciena, Cisco, Corning, Juniper, Lucent, Marconi,
Marconi, Motorola, Nortel, Scientific Atlanta, Siemens,
Motorola, Nortel, Scientific Atlanta, Siemens, Sycamore)
Sycamore), much of which collapsed at the same time
all suffered a collapse in demand at the same time
$1,200
$1,200
$1,000
$1,000
JDS Uniphase
JDS Uniphase
$800
$800
$600
$600
$400
$400
$200
$200
$0
$0
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Source: Bloomberg. July 2014.
Source: Bloomberg. July 2014.
4
4
“The personal computer will fall flat on its face in business”, Ken Olsen, CEO Digital Equipment
“The personal computer will fall flat on its face in business”, Ken Olsen, CEO Digital Equipment
Corporation, who was proclaimed “America’s most successful entrepreneur” by Fortune magazine in 1986.
Corporation, who was proclaimed “America’s most successful entrepreneur” by Fortune magazine in 1986.
21
21
21
E ye o n t h e M a r k e t

J.P. MORGAN
Eye
on
market
J.P.
E
ye o
n tthe
he M
a r k e t  •J . P
. MMorgan
ORGAN
As the tech bust rolled on through 2001 and 2002, dozens of technology companies ended up seeing
their
stock
prices
the rearview
(for example,
212 Internet
& Software
Service
As
thehighest
tech bust
rolled
oninthrough
2001 mirror
and 2002,
dozens ofoftechnology
companies
ended
up seeing
companies
with
stock
prices
in
February
2000,
only
17
ever
saw
higher
stock
prices
at
any
time
their highest stock prices in the rearview mirror (for example, of 212 Internet & Software Service
between
March
2000 and
February
2014).
Some
theever
largest
apppear
below;
first three
companies
with stock
prices
in February
2000,
onlyof17
saw declines
higher stock
prices
at anythe
time
each
had
a
peak
market
cap
over
$100
billion.
While
some
companies
survived
(EMC,
Intel,
Cisco,
between March 2000 and February 2014). Some of the largest declines appear below; the first three
Broadcom),
others
did not
adapt
industry
changes,
temporarily,
or did
not adapt
time 5.
each
had a peak
market
cap
overto
$100
billion.
While adapted
some companies
survived
(EMC,
Intel, in
Cisco,
Broadcom), others did not adapt to industry changes, adapted temporarily, or did not adapt in time 5.
The world’s largest telecom equipment company in
1999 with $38 billion in sales; relied excessively on its
The
world’sposition
largest telecom
equipment
incumbent
and did not
adapt company in
1999
with
$38
billion
in
sales;
relied
excessively on its
$60
incumbent position and did not adapt
Lucent Technologies Inc.
$60
$50
Lucent Technologies Inc.
$50
$40
$40
$30
$30
$20
$20
$10
$10
$0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
$0
Source: Bloomberg. November 2006.
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Source:
Bloomberg.
2006.Sun on hardware (to x86
Industry
shifted November
away from
processor machines), and on software (away from
Industry
shifted
away from Sun on hardware (to x86
proprietary
licensing)
processor machines), and on software (away from
$250
proprietary licensing); see footnote #5
$250
$200
$200
$150
Lucent's Canadian competitor, drowning in a sea of
overpriced, ill-chosen, poorly integrated acquisitions;
Lucent's
Canadian
competitor,
drowning
a sea of
suffered from
a "culture
of arrogance
andin
hubris"*
overpriced,
ill-chosen,
poorly
integrated
acquisitions;
$900
suffered
from
a "culture
of arrogance and hubris"*
Nortel
Networks
Corporation
$800
$900
$700
Nortel
Networks
Corporation
* according
to a study
$800
$600
released in 2014 by the
$700
*University
accordingoftoOttawa
a study
$500
$600
released
in 2014
by the
$400
Departments
of Law,
$500
University
of
Ottawa
Electrical
Engineering
and
$300
$400
Departments
Managementof Law,
$200
Electrical Engineering and
$300
$100
Management
$200
$0
$1001981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014
$0
Source: Bloomberg. July 2014.
1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014
Source:
July 2014.
SupplyBloomberg.
chain management
software leader runs into
Germany's SAP, which decides to compete and abandon
Supply
chain
management
software
leader
JV; 2008
IP judgment
against
SAP was
tooruns
little,into
too late
Germany's
SAP,
which
decides
to
compete
and
abandon
$2,500
JV; 2008 IP judgment against SAP was too little, too late
Sun Microsystems
$2,500
$2,000
Sun Microsystems
$2,000
$1,500
$150
$100
$1,500
$1,000
$100
$50
$1,000
$500
$50
$0
1987
1990
1993
1996
1999
$0
Source: Bloomberg. December 2009.
1987
1990
1993
1996
1999
2002
2005
2008
2002
2005
2008
I2 Technologies Inc
I2 Technologies Inc
$500
$0
1997
1999
2001
2003
$0
Source: Bloomberg. January 2010.
1997
1999
2001
2003
2005
2005
2007
2007
2009
2009
Source: Bloomberg. January 2010.
Source: Bloomberg. January 2010.
As for computer hardware, cheaper component parts and migration to smartphones and tablets
pulled hardware,
down several
manufacturers’
eventually
As
for computer
cheaper
componentstocks.
parts and migration to smartphones and tablets
eventually
pulled down
severalcomputers,
manufacturers’
stocks.
Too slow moving
into portable
and from
World's #1 computer system provider experiences
retailslow
to enterprise
customers
Too
moving into
portable computers, and from
declining
for customized
hardware
and a bruising
World's #1need
computer
system provider
experiences
price
war, need
can't for
execute
on transition
to mobile
declining
customized
hardware
and a bruising
$80
retail to enterprise customers
$80
$70
$60
price war, difficulty executing on transition to mobile
$70
$60
$60
$50
$60
$50
Gateway 2000
Gateway 2000
$50
$40
$50
$40
$40
$30
$40
$30
$20
$10
$20
$10
Source: Bloomberg. October 2007.
Corporation
$30
$20
$30
$20
$10
$0
1994
1996
1998
2000
$0
Source:
Bloomberg.
October
2007.
1994
1996
1998
2000
Dell Computer
Corporation
Dell Computer
2002
2004
2006
2002
2004
2006
$10
$0
1989
1992
1995
1998
2001
$0
Source:
Bloomberg.
October
2013.
1989
1992
1995
1998
2001
2004
2007
2010
2013
2004
2007
2010
2013
Source: Bloomberg. October 2013.
5
Sun Microsystems CEO Scott McNealy in 2011, on the conundrum of proprietary vs open-source code: "The
mistake
we made was putting it on our own hardware. If we hadn't metal-wrapped it, it would have been more
5
Sun Microsystems CEO Scott McNealy in 2011, on the conundrum of proprietary vs open-source code: "The
widely adopted. If we had put Solaris early on an Intel box, Linux never would have never happened. We would
mistake we made was putting it on our own hardware. If we hadn't metal-wrapped it, it would have been more
have been the operating system for all those startups." [Information Week, February 25, 2011].
widely adopted. If we had put Solaris early on an Intel box, Linux never would have never happened. We would
22
have been the operating system for all those startups." [Information Week, February 25, 2011].
22
22
Eye on the Market

Eye on the market • J.P. Morgan
J.P. MORGAN
After the dust cleared, the steady drumbeat of substantial tech stock price declines continued over the
next few years, even on stocks linked to rapidly growing wireless and video communications (each
example shows the company; the date of its peak price before the decline; and the magnitude of the
stock price decline through July 31, 2014 or the last quoted price, according to Bloomberg):
•
•
•
•
•
•
•
•
•
Travelzoo (largest publisher of travel, entertainment and local deals): December 2004, -82%
Avid Technology (commercial audio and video production software): February 2005, -89%
Intermec (automated identification and data capture, barcode scanners): September 2005, -71%
Sirf Technologies (GPS for consumer applications): February 2006, -89%
Trident Microsystems (digital processors for LCD TVs): March 2006, -99%
Brightpoint (distributor of mobile phones and other wireless products): April 2006, -68%
Digital River (e-commerce sites for software and other tech companies): November 2006, -76%
Imation Corp. (DVDs, flash drives and magnetic tapes): December 2006, -93%
THQ (video games such as Dawn of War and Company of Heroes): March 2007, -100%
Fast forward to today. Some people view the Technology sector as changed, and believe that
companies brought to market via initial public offerings are more robust. Can this be substantiated?
It depends how you define your parameters. As shown in the next chart, the median age of tech IPOs
has been rising since the height of the dot.com era;
Technology IPO trends: firm age and valuation at IPO
the median age has risen from 4 to 10 years. This
Median price/sales
Median firm age in years
does suggest a maturation of tech companies going
15
15x
public, perhaps a result of deeper pre-IPO financing
13
capital pools which allow companies to stay private
1999: 26.5
12x
2000:
31.7
longer. As for valuations, nothing will probably ever
11
9x
Median firm age
match the pricing of tech IPOs in 1999 and 2000
9
when average price/sales ratios were 27x and 32x,
6x
7
respectively. More recent valuations have been
3x
creeping up again, however, and are roughly where
5
Median price/sales
they were before the onset of the financial crisis.
3
0x
1980 1984 1988 1992 1996 2000 2004 2008 2012
There’s one area showing clear signs of rising investor
Source:
"Initial Public Offerings: Technology Stock IPOs". Ritter (Univ. of
risk appetite: the falling percentage of tech IPOs that
Florida). July 2014.
are profitable at issuance. In the last couple of
years, this measure has declined almost back to where it was during the dot.com era. From
this perspective, there’s a lot of business risk being brought to market via companies whose profitability
has not yet been established. All things considered, the business risk of today’s tech IPO may be only
moderately lower than it was 15 years ago. For more on IPOs and their performance relative to a
diversified basket of stocks, see page 34.
Remembrance of things past: low percentage of technology company IPOs with profits
Percent of technology companies with positive net income at IPO
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1980
1983
1986
1989
1992
1995
1998
2001
Source: "Initial Public Offerings: Technology Stock IPOs". Ritter (University of Florida). July 2014.
2004
2007
2010
2013
23
23
Eye
on
market
J.P.
E
ye o
n tthe
he M
a r k e t  •J . P
. MMorgan
ORGAN
To complete the tech sector review, we conclude with a few recent cases where there have been
substantial reversals of fortune. To reiterate a theme, the fact that a certain segment of the industry is
skyrocketing (e.g., the 220% growth in mobile search and display advertising since 2012) does not lift
all boats. On gaming, many mobile game developers have struggled to establish the kind of brand
loyalty that exists in traditional gaming (Madden NFL, World of Warcraft, Call of Duty) which keeps
players coming back for more. There’s also “piggy-backing” risk: companies like Zynga and Demand
Media rely to a great extent on how Facebook and Google integrate them; changes in the latter can
have very large impacts on the former. We conclude with BlackBerry. Innovation in handheld devices
and mobile phones garners a lot of interest, but these companies can be rapidly eclipsed by
competitors and changing technology. Palm, the company that pioneered personal digital assistants
and first popularized the smartphone, collapsed in 2001; then Motorola could not maintain the
advantage it had in 2006 with its revolutionary Razr phone; BlackBerry is just the latest casualty.
Google finally gets wise to "content farms" like Demand
Media, and changes algorithms to avoid them
$50
$45
$40
$35
$30
$25
$20
$15
$10
$5
$0
Jan-11
Big data flash storage leader's customer base too
concentrated (loss in pricing power); low barriers to
entry invite intense competition
$40
Fusion-io, Inc.
Demand Media, Inc.
$30
$20
$10
Jan-12
Jan-13
Jan-14
$0
Jun-11
Dec-11
Jun-12
Dec-12
Jun-13
Dec-13
Jun-14
Source: Bloomberg. July 2014.
Source: Bloomberg. July 2014.
Buying the next big hit proves to be much harder than
developing it; acquisition writeoffs, falling subscribers,
bloated management and lots of competition
Pioneer of mobile advertising gets squeezed out once
the mega-platforms (Google, Facebook) compete with
them; not every little fish gets bought
$14
$25
Millennial Media, Inc.
$12
$10
$20
Zynga Inc.
$8
$15
$6
$10
$4
$5
$2
$0
Jan-12
Jul-12
Jan-13
Jul-13
Jan-14
Jul-14
$0
Mar-12
Sep-12
Mar-13
Sep-13
Mar-14
Source: Bloomberg. July 2014.
Source: Bloomberg. July 2014.
Extreme revenue concentration for smaller technology
companies (in this case, software-defined networking)
causes problems when big customers cut back
Stale technology (no touch screen), operating system
problems, worldwide outages, too much focus on corp
customers; mine is constantly re-booting for no reason
$16
$14
$12
$150
$125
Cyan, Inc.
$10
$100
$8
$75
$6
BlackBerry Ltd.
$50
$4
$25
$2
$0
May-13
Aug-13
Nov-13
Source: Bloomberg. July 2014.
Feb-14
May-14
$0
1999
2001
2003
2005
2007
2009
2011
2013
Source: Bloomberg. July 2014.
24
24
Eye on the Market

Eye on the market • J.P. Morgan
J.P. MORGAN
Materials
The Deng reforms in China and the Rao reforms in India are among the most momentous shifts in
relative economic power in centuries. In both countries, capital and energy-intensive industries like iron
and steel benefited from very generous government subsidies (see Appendix I). As these state-sponsored
companies became more profitable, their earnings were reinvested, creating expansion of capacity and
production well beyond their domestic markets’ ability to absorb. This resulted in a structural change in
global export markets, and intense competition for US firms. Other secular, permanent shifts: the
decline in US newspaper readership from 62 million daily (1990) to 52 million (2006), a problem for
newspaper companies and the Materials companies that sell newsprint to them. As for cyclical risks,
many Metals & Mining companies were not well positioned for the 20% collapse in global trade which
took place in 2009, the largest decline in 50 years (e.g., Alcoa, US Steel, AK Steel, Intrepid Potash all
suffered sharp declines and have not yet substantially recovered).
Deng reforms in China reshape steel export market,
management did not reduce labor costs or increase
plant productivity in time
$35
$35
$30
$30
Low margin packaging business with too much
leverage suffers from a collapse in trade during the
global recession
$25
Bethlehem
Steel Corp.
Corp.
Bethlehem Steel
Annual
Chineseiron
iron
Annual Chinese
and
steel exports
exports
and steel
jump
from $1.6B
$1.6Bto
to
jump from
$5.2B
$5.2B
$25
$25
$20
$20
$15
$15
$20
$15
$10
$10
$10
Smurfit-Stone Container Corp.
$5
$5
$5
$0
$0
1981 1983
1983 1985
1985 1987
1987 1989
1989 1991
1991 1993
1993 1995
1995 1997
1997 1999
1999 2001
2001 2003
2003
1981
Source: Bloomberg.
Source:
Bloomberg.January
January2004.
2004.
No statute of limitations: environmental misdeeds, even
2-3 decades after they take place, can threaten a
company's solvency
$0
1995
1997
1999
2001
2005
2007
2009
"Rare earth demand is insatiable since the entire
electronics and renewable energy industry depends on
them!!" That is, until workarounds are found
$80
$35
$70
$30
$60
$25
$50
Solutia
$20
Molycorp, Inc.
$40
$15
$30
$10
$20
$5
$10
$0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
$0
Source: Bloomberg. February 2008.
Source: Bloomberg. July 2014.
An indirect internet casualty: declining newspaper
demand leads to collapse in the demand for newsprint
$20
$18
$16
$14
$12
$10
$8
$6
$4
$2
$0
1990
2003
Source: Bloomberg. June 2010.
Abitibi-Consolidated Inc.
1992
1994
1996
1998
Source: Bloomberg. October 2007.
2000
2002
2004
2006
2011
2012
2013
2014
Alcoa's fortunes hurt by global over-expansion of
capacity which drags down producer profits; a leveraged
reflection of global growth and capex
$45
Aluminum Company of America
$40
Similar profiles in metals/
$35
mining due to collapse in global
$30
trade: US Steel, AK Steel,
$25
Walter Energy, Intrepid Potash,
Century Aluminum, Thompson
$20
Creek
$15
$10
$5
$0
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013
Source: Bloomberg. July 2014.
25
25
Eye
market
Morgan
E y e on
o n the
the M
a r k e t  •J .J.P.
P. M
ORGAN
Telecommunications
While the period from 1999-2001 is often referred to as the dot-com bust, the telecommunications
industry accounted for much more equity market capitalization both gained and then lost. The lesson:
regulatory shifts can make it difficult to forecast supply and demand. The catalyst for change was the
Telecommunications Act of 1996, which was designed to bring competition to the local exchange level
(by 1996, long distance service was already subject to competition, although the Act also allowed
incumbent local carriers to compete in long distance markets). The combination of deregulation and
advances in fiber optic technology resulted in the belief that a single firm could provide all of a given
household’s or company’s telecom needs. Demand for bandwidth proliferated; from 1994 to 1996,
internet traffic in the US increased from 16 to 1,500 terabytes per month. Meanwhile, the Act was
constantly tied up in the courts since the FCC left many of the Act’s clauses open to interpretation or
dispute (in particular, disputes over the FCC’s jurisdiction regarding forced co-location and other rules
requiring incumbents to make room for new competitors).
A gold rush of investment followed: at the peak of the cycle, telecom capital spending was
skyrocketing and industry profitability was negative. In hindsight, a buoyant IPO market and the
willingness of telecom equipment sellers (Lucent, Nortel, Motorola, Alcatel and Cisco) to provide
vendor financing were signs of industry weakness. In the early 2000’s, end-user demand for long-haul
fiber did not rise as quickly as telecom companies projected. As a result, a glut of excess capacity,
lower tolling rates and too much debt caused a collapse in telecom stock prices by 2003 and a wave of
bankruptcies (see box, below). Video streaming and other data-heavy trends that the telecom giants
expected eventually appeared, several years later; however, leveraged capital structures could not wait
that long. The importance of this episode for concentrated stockholders is not that a telecom boombust will necessarily repeat itself, but that the paradigm might take place elsewhere.
Private fixed investment in communications
Communication industry after-tax profits
Billions of 2009 USD (both axes)
$90
$80
USD, billions
$30
Communications
structures
$25
$20
$25
$70
$15
$10
$60
Communications
equipment
$50
$5
$20
$0
-$5
$40
$30
1995
$30
-$10
$15
1997
1999
2001
2003
Source: Bureau of Economic Analysis. December 2003.
-$15
1995
1996
1997
1998
1999
2000
2001
Source: Bureau of Economic Analysis, J.P. Morgan Asset Management. 2001.
2000-2003 Telecom bankruptcy wave (partial)
Long distance/wholesale fiber carriers: Global Crossing, GTS, 360Networks, Impsat, Network Plus, Star,
Touch America, Viatel, WorldCom
Competitive local exchange carriers: Convergent, Covad, Focal, ICG, McLeod, Northpoint, NTL, Rhythms
Net, Telcove, XO (After FCC rulings that originally favored the new competitive local exchange carriers, an
FCC ruling in 2000 on pricing methodology went against them)
Wireless carriers: GlobalStar, Leap, Metricom, OmniSky, StarBand, Teligent, Winstar
Diversified/Other: Excite@Home
26
26
Eye on the Market

Eye on the market • J.P. Morgan
J.P. MORGAN
The box on the prior page lists the companies that filed Chapter 11. Others survived the telecom bust,
but their stock prices look like Sprint (below) which only recaptured a fraction of its lost market cap (in
the case of Sprint, it was acquired in July 2013 by Japan’s SoftBank). Other examples of partial stock
price recoveries include Qwest, US Cellular, Level 3 and Arch Wireless. Only a handful of telecom
survivors look like Bell South, Alltel and SBA Communications, whose stock prices declined during the
telecom crash and then rebounded substantially, reaching or surpassing prior stock price peaks.
Third largest wireless and wireline company barely
survived telecom boom-bust and a failed 2004 $36
billion merger with Nextel
Examples of recovering telecom stocks
Index = 100 at February 2000
250
$70
$60
200
$50
Sprint Communications
150
$40
$30
SBA Communications
Bell South
(acquired)
Alltel
(acquired)
100
$20
50
$10
$0
1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011
0
1996
1997
1999
2001
2003
2005
2007
2009
2011
2013
Source: Bloomberg. July 2014.
Source: Bloomberg. July 2013.
There were also telecom declines that took place after the telecom boom-bust that are worth
reviewing. Like biotech and internet stocks, while the period of peak business failure was 2000-2002,
telecom companies are still subject to traditional business cycle and management risks.
Differentiated product (unlimited minutes for low-end
customers) attracts competition from proxies funded by
large wireless companies using superior 4G technology
$90
$80
$70
$60
$50
$40
$30
$20
$10
$0
2005
Not all wireless service created equal: higher frequency
spectrum has shorter coverage areas and weaker
penetration strength; eventually surpassed by broadband
$30
$25
Clearwire Corporation
Leap Wireless International Inc.
$20
$15
$10
$5
2006
2007
2008
2009
2010
2011
2012
2013
2014
$0
2007
2008
2009
2010
2011
2012
Source: Bloomberg. March 2014.
Source: Bloomberg. July 2013.
VOIP*: revolutionary idea gets old fast when Skype
offers basic service for free, cable companies compete
and wireless companies file patent infringement suits
Iridium failure ten years prior was the template for
satellite phone technology that did not live up to
expectations
$30
$14
$12
2013
*VOIP = Voice Over Internet Protocol
$10
$25
Vonage Holdings Corp.
TerreStar Corp.
$20
$8
$15
$6
$10
$4
$5
$2
$0
May-06
May-08
Source: Bloomberg. July 2014.
May-10
May-12
May-14
$0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: Bloomberg. March 2013.
27
27
Eye
on
market
E
ye o
n tthe
he M
a r k e t  •J . J.P.
P . MMorgan
ORGAN
Utilities (power generation, transmission and distribution)
Utility catastrophic stock price declines are less frequent than in other sectors (there were no private
sector utility defaults between the Great Depression and a New Hampshire utility failure in 1988).
However, when they happen, they tend to be large. The largest was of course Enron, the catalyst for
Sarbanes-Oxley and other regulations that followed. The distraction of Enron in a concentrated stock
discussion is that accounting fraud is generally not the biggest risk for utilities. Instead, there are
parallels with telecommunications: (a) deregulation led to a variety of unanticipated market
outcomes and business failures, and (b) there was a poorly timed capacity glut financed with leverage.
At times, mismatches between reimbursement mechanisms and changing commodity prices and
electricity demand were the cause of severe declines (e.g., PG&E bankruptcy in 2001, when the state of
California required the company to sell power at fixed prices regardless of its rising out-of-state
electricity acquisition costs). The separation of generation from transmission in many states also took
away a degree of income stability from formerly diversified utilities.
The first chart shows the increase in natural gas capacity at the end of the 1990’s. Much of it was
fueled by the view that coal plant de-commissioning would accelerate, either due to voluntary decisions
by utilities that owned them, or due to EPA regulations. However, when natural gas prices rose from
their lows in 2001, utilities did not de-commission coal plants that quickly. Furthermore, electricity
price spikes in the year 2000 led many companies to make massive additions to future natural gas
capacity, financed with debt; this was a mis-read of underlying supply/demand conditions, as electricity
prices soon corrected, particularly in California. The glut of unused plants and a sharp decline in
electricity prices in the summer of 2001 (due to increased capacity, mild weather and weaker demand)
led to sharply declining utility stock prices. The subsequent rise in natural gas input costs from 2001 to
2006 eventually pushed some companies into bankruptcy (Calpine, NRG, Mirant, NEGT) and heavily
damaged others (Dynegy) when their contracts did not adjust sufficiently for rising gas input prices.
Natural gas powered capacity additions
Spike in California wholesale spot electricity prices
was not a reflection of a permanent supply shortage
Gigawatts of electricity generating capacity additions
Dollars per MWh
60
50
40
30
20
10
0
1990
1993
1996
1999
2002
2005
Source: Energy Inf ormation Administration. 2013.
2008
2011
$1,000
$900
$800
$700
$600
$500
$400
$300
$200
$100
$0
Apr-00
Jul-00
Oct-00
Jan-01
Apr-01
Jul-01
Oct-01
Source: Western Price Survey, Energy NewsData Corporation. October 2001.
US natural gas prices
Dollars per MMbtu, generic front month US natural gas price
$16
$14
Rising prices, a problem
for unhedged buyers
$12
$10
$8
$6
$4
$2
$0
2000
2001
2002
2003
2004
2005
2006
Source: Bloomberg. December 2006.
28
28
Eye on the Market

Eye on the market • J.P. Morgan
J.P. MORGAN
In the charts below, Calpine and Reliant are proxies for utility distress that took place as a result of the
1999-2003 capacity expansion in natural gas plants. There were other reasons for utility distress
outside this period, such as under-appreciation of emerging market risks (AES). In the case of Exelon,
changing energy policies and commodity supply created a formidable headwind: its nuclear-heavy
generation portfolio is in less demand since the natural gas boom and renewable energy production tax
credits make other forms of generation cheaper. In addition, renewable portfolio standards drive grid
operators towards more wind/solar. As for Constellation Energy, we might have included it in the
Financials section given its January 2007 launch of an energy trading business that created huge
problems: the company had to arrange a fire sale when a pending downgrade could have required a
collateral posting of $4 billion. This was not the first time that utilities suffered from outsized energy
trading operations: problems earlier in the decade at Dynegy, Williams, Aquila and El Paso were similar.
Over-reliance on leverage (85%) despite a transition
from fixed price contracts to merchant pricing; at one
point, 115% of capacity under construction
First leg: rising fuel input costs combined with $5bn debt
increase from 2002 to 2003; Second leg: asset sales not
completed fast enough before recession/liquidity crisis
$40
$60
$35
$50
$30
$40
$25
$30
$20
$20
$15
Calpine Corp.
$10
Reliant Energy Inc.
$10
$5
$0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: Bloomberg. February 2008.
$0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Massive overseas expansion (esp. Latin America)
backfires after 65%-75% currency declines, adverse
regulatory rulings in Brazil and falling global demand
Exelon portfolio: 55% nuclear at a time of rising nuclear
maintenance costs, and falling prices of natural gas
and wind-powered electricity
Source: Bloomberg. December 2012.
$70
$100
$90
$80
$50
$70
$60
$40
$50
$30
Exelon
AES Corporation
$40
$30
$20
$20
$10
$10
$0
$0
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014
$60
Source: Bloomberg. July 2014.
Source: Bloomberg. July 2014.
Consequence of energy trading becoming a primary
strategic focus, rather than the generation of wholesale
power
Wholesale ownership and distribution of water was an
immature market, limited ability to recapture capital
spending outlays
$120
$25
$100
$20
$80
$60
Constellation Energy
$15
$10
$40
$20
$0
1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011
Source: Bloomberg. March 2012.
Western Water
Company
$5
$0
1993
1995
1997
1999
2001
2003
2005
Source: Bloomberg. February 2006.
29
29
Eye
on
market
E
ye o
n tthe
he M
a r k e t  •J . J.P.
P . MMorgan
ORGAN
Subsector focus on alternative energy stocks
In our 2014 annual energy paper, we write about the practical certainty of the world’s eventual
transition to renewable energy. This transition will be the fourth of the last few hundred years, with
the first three being coal (early 1800’s), oil (early 1900’s) and natural gas (mid 1900’s). However, the
journey to a renewable energy world will be long, and subject to fits and starts regarding what works
and what doesn’t. The next chart is one way of visualizing the risks and opportunities for concentrated
holders. It shows how the returns on two diversified clean energy indexes have usually underperformed
the S&P Small Cap Index. The peaks and valleys are huge, with more valleys than peaks; new ideas
often generate tremendous excitement, but only a few work out in the long run.
Renewable energy stocks fall in and out of favor
Rolling 1-year excess return of clean energy vs. S&P small cap
70%
NYSE Bloomberg AME
Clean minus S&P Small
Cap Index
50%
30%
10%
-10%
-30%
-50%
Wilderhill Clean Energy Index
minus S&P Small Cap Index
-70%
2002
2004
2006
2008
2010
2012
Source: Bloomberg. July 31, 2014.
The table below shows a few more comparisons. Clean energy stocks have struggled versus both the
broad market and versus the oil & gas stocks which make up the majority of energy-specific S&P subindices. The relative returns are similar when starting the analysis in 2002, 2005 or 2008, or when
using different clean/alternative energy indices.
The underperformance of alternative energy stocks
Annualized Total Returns
Index
Clean Energy Indices:
Wilderhill Clean Energy Index
NYSE Bloomberg Americas Clean Energy Index
FTSE Environmental Opps. Renewable & Alternative Energy Index
Benchmark Indices:
S&P Small Cap
S&P Small Cap Energy
S&P Mid Cap
S&P Mid Cap Energy
S&P 500
S&P Large Cap Energy
Since 2002
Since 2005
Since 2008
-3.04%
**
**
-10.08%
4.61%
**
-4.11%
11.82%
1.90%
12.01%
20.01%
12.04%
12.19%
9.21%
14.64%
8.60%
12.49%
9.03%
5.59%
7.47%
9.87%
18.39%
25.04%
19.98%
18.41%
17.06%
13.71%
Source: Bloomberg. July 31, 2014. ** represents indexes prior to their inception.
30
30
Eye on the Market

Eye on the market • J.P. Morgan
J.P. MORGAN
There may be no sector whose stocks have more true believers than alternative energy and related
services/products. This category includes companies developing wind and solar equipment, fuel cells
and biofuel processes. It also includes companies in search of superconductor materials, which would
save the world enormous amounts of energy by reducing the 6%-10% of electricity that is lost on
alternating current transmission lines and across other synapses. Unfortunately, while each of the ideas
below may one day become integral and indispensable, there are issues related to pricing, subsidies,
government regulations, overseas competition, raw materials costs, carbon emission taxes (or the lack
thereof), capacity factors/efficiency and the practical limits of science that can get in the way. We
chose some of the better known examples below; each was seen in its day as a “magic bullet”, only to
see dramatic reversals of fortune.
Manufacturer of thin film photovoltaic solar panels,
provider of PV power plants/services
Wind turbine manufacturing and services
$300
$300
$250
Broadwind Energy, Inc.
$250
$200
$150
$150
$100
$100
$50
$50
$0
2006
First Solar, Inc.
$200
2007
2008
2009
2010
2011
2012
2013
2014
$0
2007
2008
2009
Source: Bloomberg. July 2014.
Source: Bloomberg. July 2014.
Hydrogen fuel cells
Superconductors
2010
2011
2012
2013
2014
$80
$120
$70
$100
Ballard Power Systems Inc.
American Superconductor Corporation
$60
$80
$50
$40
$60
$30
$40
$20
$20
$0
1996
$10
1998
2000
2002
2004
2006
2008
2010
2012
2014
$0
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Source: Bloomberg. July 2014.
Source: Bloomberg. July 2014.
Next generation renewable biofuels
Environmentally friendly fast-food containers
$180
$20
$160
$15
KiOR Inc.
$140
Earthshell Corp.
$120
$100
$10
$80
$60
$5
$40
$20
$0
Jul-11
Jul-12
Source: Bloomberg. July 2014.
Jul-13
Jul-14
$0
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Source: Bloomberg. August 2007.
31
31
Eye
on
market
E
ye o
n tthe
he M
a r k e t  •J . J.P.
P . MMorgan
ORGAN
A look at the winners (The Ecstasy)
We include an exhibit on the following page that shows the historical extreme winners. As explained
earlier, we defined these winners as having generated more than a two standard deviation return over
the Russell 3000 Index since their inception. There are several hundred of them in our database, which
is too many to list here. Instead, we show a subset: stocks that generated the highest excess lifetime
returns over the Russell 3000 Index, which are currently active (i.e., excluding inactive stocks that
generated outsized returns before being acquired, merged etc.), and which have a current market
capitalization over $5 billion.
This is a very heterogeneous list of companies. Some have been quite volatile; many technology
companies suffered substantial declines during the tech bust, and have been on a tear since then (eBay,
Qualcomm, Amazon). Some took decades to generate substantial wealth, while others accomplished it
in a few short years. Some have not generated substantial returns to holders in many years, and
instead experienced rapid appreciation during the 1990’s. Despite their differences, over the long
haul, all of them generated substantial excess returns relative to their initial reported public
stock price (excluding any pre-IPO wealth creation). Consumer Discretionary and Technology
show a large number of success stories; these are the survivors, since both sectors also generated the
largest number of catastrophic declines.
We prepared this list at the time this document was drafted, in the summer of 2014. If history is any
guide, the drumbeat of business distress outlined on pages 3-5 will eventually ensnare some of them.
32
32
Eye on the market • J.P. Morgan
o nt hteh eMM
. O
MROGRAGNA N
EE
yey eo n
a rakrekte t J. PJ . PM
Historical
list
(see
prior
page
forfor
details);
sector
designations
as per
FactSet
HistoricalWinners
Winners
list
(see
prior
page
details);
sector
designations
as per
FactSet
Consumer Discretionary
Consumer Discretionary
Amazon.com,
Inc.
Amazon.com,
AutoZone,
Inc. Inc.
AutoZone,
Inc. Inc.
Bed
Bath & Beyond
BedBuy
Bath
& Inc.
Beyond Inc.
Best
Co.,
Best Buy
Co., Inc.
Comcast
Corporation
Dillard
Inc. Corporation
Comcast
Dish
Network
Dillard
Inc. Corp.
Dollar
Inc. Corp.
DishTree
Network
Family
Dollar
Dollar
TreeStores,
Inc. Inc.
Fossil
Inc.Dollar Stores, Inc.
Family
Gap,
Inc.Inc.
Fossil
Harley-Davidson,
Inc.
Gap, Inc.
Hasbro,
Inc.
Harley-Davidson, Inc.
Home Depot, Inc.
Hasbro, Inc.
L Brands Inc.
Home Depot, Inc.
Lowe's Companies, Inc.
L Brands Inc.
McDonald's Corporation
Lowe's Companies, Inc.
Netflix, Inc.
McDonald's Corporation
NIKE, Inc.
Netflix, Inc.
Nordstrom, Inc.
NIKE, Inc.
O'Reilly Automotive, Inc.
Nordstrom, Inc.
Polaris Industries Inc.
O'Reilly
PVH
Corp. Automotive, Inc.
Polaris
Industries
Inc.
Ross Stores,
Inc.
PVH
Corp.
Starbucks Corporation
Ross Corp.
Stores, Inc.
Target
Starbucks
Tiffany
& Co. Corporation
Target
Corp.
Time
Warner
Inc.
Tiffany
& Co. Inc.
TJX
Companies,
Time
Warner
Toll
Brothers,
Inc.Inc.
TJX Companies,
Inc.
Tractor
Supply Company
V.F.
TollCorporation
Brothers, Inc.
Walt
Disney
Company
Tractor
Supply
Company
Williams-Sonoma,
Inc.
V.F. Corporation
Wynn
WaltResorts,
Disney Limited
Company
Williams-Sonoma, Inc.
Consumer
Staples
Wynn Resorts,
Limited
Brown-Forman Corporation
Church
& Dwight
Co., Inc.
Consumer
Staples
Clorox Company
Brown-Forman Corporation
Colgate-Palmolive Company
Church & Dwight Co., Inc.
Constellation Brands
Clorox Company
Hershey Company
Colgate-Palmolive Company
Hormel Foods Corporation
Constellation Brands
J. M. Smucker Company
Hershey Company
Keurig Green Mountain Inc.
Hormel Foods Corporation
Monster Beverage Corp.
J. M. Smucker Company
Sysco Corporation
Keurig
Green
Tyson
Foods,
Inc.Mountain Inc.
MonsterCo.
Beverage Corp.
Walgreen
Sysco Corporation
Wal-Mart
Stores, Inc.
TysonFoods
Foods,
Inc. Inc.
Whole
Market,
Walgreen Co.
Wal-Mart Stores, Inc.
Whole Foods Market, Inc.
Energy
Energy
Cheniere
Energy, Inc.
Cheniere
Energy,
Core
Laboratories
NV Inc.
Core Laboratories
Energen
Corporation NV
Energen
Corporation
EOG
Resources
EOG
Resources
EQT
Corp.
HollyFrontier
EQT Corp.Corp.
Patterson-UTI
Energy,
Inc.
Corp.
HollyFrontier
Patterson-UTI Energy, Inc.
Financials
AFLAC
Inc.
Financials
Berkshire
Inc.
AFLACHathaway
Inc.
BlackRock,
BerkshireInc.
Hathaway Inc.
Charles
SchwabInc.
Corporation
BlackRock,
Franklin Resources, Inc.
Charles Schwab Corporation
Leucadia National Corporation
Franklin Resources, Inc.
M&T Bank Corp.
Leucadia National Corporation
Markel Corporation
M&T Bank Corp.
Northern Trust Corporation
Markel Corporation
Progressive Corporation
Northern Trust Corporation
Raymond James Financial, Inc.
Progressive Corporation
SEI Investments Company
Raymond James Financial, Inc.
State Street Boston Corporation
SEIFinancial
Investments
SVB
GroupCompany
State
Street
Boston
T. Rowe Price Group
Inc.Corporation
SVB
Financial
Group
TD Ameritrade Holding Corp.
T. RoweCorporation
Price Group Inc.
Torchmark
Holding Corp.
Ameritrade
W.TD
R. Berkley
Corporation
Torchmark Corporation
W. R.Care
Berkley Corporation
Health
Actavis PLC
Care
Health
Alexion
Pharmaceuticals,
Inc.
Amgen
Inc.PLC
Actavis
Biogen
IDECPharmaceuticals,
Inc.
Alexion
Inc.
C. Amgen
R. Bard, Inc.
Inc.
Cardinal
BiogenDistribution,
IDEC Inc. Inc.
Catamaran
Corporation
C. R. Bard,
Inc.
Celgene
Corporation
Cardinal Distribution, Inc.
Cerner
Corporation
Catamaran
Corporation
DENTSPLY
Inc.
CelgeneInternational
Corporation
Express Scripts Holding Company
Cerner Corporation
Forest Laboratories, Inc.
DENTSPLY International Inc.
Gilead Sciences, Inc.
Express Scripts Holding Company
IDEXX Laboratories, Inc.
Forest Laboratories, Inc.
Incyte Corporation
Gilead Sciences, Inc.
Intuitive Surgical, Inc.
IDEXX Laboratories, Inc.
Medivation, Inc.
Incyte Corporation
Medtronic, Inc.
Intuitive Surgical, Inc.
Mylan Inc.
Medivation,
Inc.
ResMed
Inc.
Medtronic,
Inc. Ltd.
Salix
Pharmaceuticals,
Inc. Inc.
St. Mylan
Jude Medical,
ResMed
Inc.
Stryker
Corporation
Salix
Pharmaceuticals,
Ltd.
United HealthCare Corporation
St. Jude
Medical,
Inc.Inc.
Universal
Health
Services,
Stryker
Corporation
Waters
Corporation
United HealthCare Corporation
Universal Health Services, Inc.
Waters Corporation
Industrials
Industrials
Cintas
Corporation
Cintas Corporation
Danaher
Corporation
Danaher Corporation
Donaldson
Company, Inc.
Donaldson
Equifax
Inc. Company, Inc.
Equifax Inc.
Expeditors
International of Washington, Inc.
Fastenal
Company
Expeditors
International of Washington
Genesee
Wyoming, Inc.
Fastenal& Company
Illinois
Tool &
Works
Inc. Inc.
Genesee
Wyoming,
Jacobs
Group
Tool Works
Inc. Inc.
IllinoisEngineering
Precision
Castparts Corp.
Jacobs Engineering
Group Inc.
Roper
Industries,
Inc. Corp.
Precision
Castparts
Southwest
Airlines Co.
Roper Industries,
Inc.
Stericycle,
Inc.
Southwest Airlines Co.
Materials
Airgas, Inc.
Ball Corporation
CF Industries Holdings, Inc.
Ecolab Inc.
FMC Corporation
Sherwin-Williams Company
Sigma-Aldrich Corporation
Valspar Corporation
Stericycle, Inc.
Information Technology
Adobe Systems Incorporated
Information Technology
Alliance Data Systems Corporation
Adobe Systems Incorporated
Altera Corporation
Alliance Data Systems Corporation
Amphenol Corporation
Altera Corporation
Analog Devices, Inc.
Amphenol Corporation
ANSYS, Inc.
Analog Devices, Inc.
Apple Inc.
ANSYS,
Inc.
Applied
Materials,
Inc.
Apple
Inc.
Autodesk, Inc.
Applied Materials,
Inc. Inc.
Automatic
Data Processing,
Autodesk,
Inc.
CA
Inc.
Automatic
Data
Cisco
Systems,
Inc. Processing, Inc.
CA Inc. Technology Solutions Corp.
Cognizant
Cisco
Cree
Inc.Systems, Inc.
Cognizant
Technology Solutions Corp.
eBay
Inc.
Cree Inc.Arts Inc.
Electronic
EMC
eBayCorporation
Inc.
FactSet
Research
Inc.
Electronic
Arts Systems
Inc.
Fiserv
EMCInc.
Corporation
Intel
Corporation
FactSet
Research Systems Inc.
Intuit
Inc.
Fiserv
Inc.
Linear
Intel Technology
CorporationCorporation
MasterCard
Intuit Inc. Incorporated
Maxim
Products,
Inc.
LinearIntegrated
Technology
Corporation
Microchip Technology Inc.
MasterCard Incorporated
MICROS Systems, Inc.
Maxim Integrated Products, Inc.
Microsoft Corporation
Microchip Technology Inc.
Oracle Corporation
MICROS Systems, Inc.
Paychex, Inc.
Microsoft Corporation
QUALCOMM Incorporated
Oracle Corporation
salesforce.com inc.
Paychex, Inc.
Total System Services, Inc.
QUALCOMM Incorporated
Xilinx, Inc.
salesforce.com
inc.
Yahoo!
Inc.
Total System Services, Inc.
Xilinx, Inc.
Materials
Yahoo!
Airgas,
Inc.Inc.
Ball Corporation
CF Industries Holdings, Inc.
Ecolab Inc.
FMC Corporation
Sherwin-Williams Company
Sigma-Aldrich Corporation
Valspar Corporation
Important
Note: these
theseare
arenot
notrecommendations,
recommendations,and
andthe
thecompany
company
is purely
based
historical
analyses
Important Note:
listlist
is purely
based
onon
historical
analyses
andand
information
which
is
never
a
guarantee
of
future
results
or
success.
information which is never a guarantee of future results or success.
33
33
33
EEye
y e oon
n tthe
h e Mmarket
a r k e t  J•. PJ.P.
. MMorgan
ORGAN
The performance of IPOs vs. the broad market
While results obviously vary by stock, there are some observations one can make regarding the
aggregate performance of IPOs after they are issued. Using over 7,000 IPOs since 1980, one can
evaluate post-IPO performance (i.e., after the first day’s close) for 3 years and compare it to the broad
market, and also to a group of stocks with similar market cap and book-to-market ratios. The charts
below show the results based on the year of the IPO. There are obviously large differences between
individual stocks, but overall, the results do not point to consistently outsized post-IPO
performance when compared to diversified equity market alternatives.
Post-IPO returns vs. the market
Post-IPO returns vs. similar style firms
Average 3-year buy and hold IPO return vs. the market
Average 3-year buy and hold IPO return vs. the similar style firms
40%
40%
20%
20%
0%
0%
-20%
-20%
-40%
-40%
-60%
-60%
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12
Source: "Initial Public Offerings: Updated Statistics on Long-run Performance". Ritter (Univ. of Florida). April 2014.
Note: Returns for stocks within 3 years of IPO are through 12/31/2013. Ritter defines the broad market using an index from the Chicago
Booth School (Center for Research in Security Prices) which incorporates all stocks on the Amex, Nasdaq and NYSE exchanges.
A closer look at the results shows that small firm IPOs tend to perform worse than larger ones, with the
cutoff for “small” being $50 million in sales (in 2011 dollars). This is particularly true in technology and
biotech IPOs.
On being an insider, and other issues related to concentrated ownership
Concentrated holders have some important decisions to make: the situs where the stock is held, and
the entity in which the stock is held (for example, a grantor or non-grantor trust). There are also
choices between lifetime gifting and a step-up in basis at death that impact family wealth differently.
Non-insider holders seeking to reduce exposure may want to explore options-based strategies as
alternatives to outright selling. When the latter course is chosen, there are a range of decisions that
holders should be familiar with (exchange funds, issues related to charitable giving to family
foundations, and how to structure a selling program in terms of volume, order type and
primary/secondary offerings).
There are often restrictions on insiders selling their positions; however, there are means by which
insiders can reduce exposure over time. For example, rule 10b5-1 allows for carefully planned
trading programs that may protect the insider from a claim of having made an investment decision
while in possession of material inside information. Such a program, once established, allows trades to
be made at any time, thereby freeing insiders from the prohibitions on trading during “closed window
periods” that normally apply. When executed properly, they have the potential to mitigate signaling
issues generally associated with sales by insiders.
34
34
Eye on the Market

Eye on the market • J.P. Morgan
J.P. MORGAN
What about taxes?
It usually does not make sense to let the tax tail wag the dog; in other words, good and bad
investment ideas rarely distinguish themselves based on taxes. In the case of concentrated stock
positions, this is usually (but not always true): taxes need to be considered given the treatment of lowbasis stock upon death (it receives a step-up in basis). As a result, older owners of concentrated stock
interested in reducing exposure have to take into account the potential tax freight involved with
diversification. There are a lot of scenarios one can assume; based on our findings, in most of them,
taxes do not have a large impact on the outcome.
Let’s assume the following. A concentrated holder wants to reduce exposure, has a basis that is 20%
of the current stock price, and has no unrealized losses available to mitigate the gain. Including taxes
related to the Affordable Care Act (Medicare surtax), the total Federal long-term capital gains rate
would be 23.8%. The owner wants to maintain exposure to equity markets, just not in concentrated
form, and intends to invest the sales proceeds in the Russell 3000 Index. To maximize the amount in
the diversified portfolio, the owner sells the stock, invests in the Russell 3000 and borrows the proceeds
to pay taxes due at an interest rate of 4%. The loan is repaid at the end of the holding period.
The grid below shows two variables that affect the outcome: how the stock performs relative to the
Russell 3000 Index after the sale, and the time horizon, which reflects how long the owner would have
held the stock otherwise (until a step-up in basis at death). As shown, the primary driver is how well
the stock performs vs. the market. If the stock outperforms, then with 20-20 hindsight, selling is
negative. On the other hand, if the stock underperforms the market after the sale, there would almost
always be a benefit to selling. Only in a small number of cases (shown in red) would the impact
of taxation on its own negate the benefits of selling, if in fact the stock underperforms the
market. As a result, for most concentrated holders (excluding those at a very advanced age), we do
not believe that the tax issue should drive the diversification discussion.
Annualized gain (loss) from disposition of concentrated stock and purchase of Russell 3000 Index
Excess annual return of Russell 3000 Index
over concentrated stock position
Holding period until step-up in basis (years)
-15.0%
-12.5%
-10.0%
-7.5%
-5.0%
-2.5%
0.0%
2.5%
5.0%
7.5%
10.0%
12.5%
15.0%
3
-21.5%
-19.0%
-16.5%
-14.0%
-11.5%
-9.0%
-6.5%
-4.0%
-1.5%
1.0%
3.5%
6.0%
8.5%
6
-17.9%
-15.4%
-12.9%
-10.4%
-7.9%
-5.4%
-2.9%
-0.4%
2.1%
4.6%
7.1%
9.6%
12.1%
9
-16.7%
-14.2%
-11.7%
-9.2%
-6.7%
-4.2%
-1.7%
0.8%
3.3%
5.8%
8.3%
10.8%
13.3%
12
-16.2%
-13.7%
-11.2%
-8.7%
-6.2%
-3.7%
-1.2%
1.3%
3.8%
6.3%
8.8%
11.3%
13.8%
15
-15.8%
-13.3%
-10.8%
-8.3%
-5.8%
-3.3%
-0.8%
1.7%
4.2%
6.7%
9.2%
11.7%
14.2%
18
-15.6%
-13.1%
-10.6%
-8.1%
-5.6%
-3.1%
-0.6%
1.9%
4.4%
6.9%
9.4%
11.9%
14.4%
21
-15.5%
-13.0%
-10.5%
-8.0%
-5.5%
-3.0%
-0.5%
2.0%
4.5%
7.0%
9.5%
12.0%
14.5%
24
-15.4%
-12.9%
-10.4%
-7.9%
-5.4%
-2.9%
-0.4%
2.1%
4.6%
7.1%
9.6%
12.1%
14.6%
Note: assuming an annualized return on the Russell 3000 Index of 8%
The number of shaded red cells in the table above would not change much if we were to assume a
lower annual return on the Russell 3000 Index; the inclusion of state capital gains taxes; or the absence
of a loan (i.e., paying the tax on capital gains when due). Finally, there are strategies which involve
diversification via charitable giving, derivatives and other security arrangements which do not entail the
current recognition of taxable gains.
35
35
Eye
market
Morgan
E y e on
o n tthe
he M
a r k e t  •J .J.P.
P. M
ORGAN
Some final thoughts on managing concentrated stock positions
Great fortunes have been created by visionaries who seized a unique opportunity and work singlemindedly to realize their ambition. Concentration is an effective engine of wealth creation: it helped
drive the success of all 10 of the top 10 on the Forbes magazine list of world billionaires in 2014. In the
US, the top 10 of the “Forbes 400” also made their fortunes through concentration.
As difficult as it is to build a company and amass wealth, it is just as difficult to keep fortunes aloft. Our
analysis (and others before it) demonstrates the hard reality that, all too often, continued concentration
may ultimately destroy wealth. Since the early 1980’s, 40% of all companies experienced a severe loss
and never recovered, with higher loss rates in Technology, Biotech and Consumer Discretionary. As
this study lays out, no matter how well you know your industry and your company, no one is
impervious to event risk and industry changes. The factors outside management control shown
on page 11 are a formidable list, and have grown in complexity since we first drafted this
report 10 years ago. This is perhaps the most important epiphany we gained from the study: that
exogenous forces may overwhelm the things we can control.
Despite this, often the natural impulse is to leave well enough alone. After all, if concentration’s
rewards have been so enormous, why not stay concentrated? Some may be concerned that
“diversification” translates directly into “selling the business.” It does not. While you could sell all or
part of your business, you might also consider taking some capital out of your business or use leverage
to create a complementary portfolio. In doing so, a concentrated owner can take out some insurance
against the unknown.
The process of addressing concentration starts with some personal choices about risk and the fate of
future generations. While no plan is ever perfect, taking no action may be worse. The first step in the
journey is to look at the overarching question of what you want to achieve in the long run, now that
the wealth has been created. If you want your fortune to be enjoyed by your family for generations,
you will need to create a plan that encourages guided consumption, as well as wealth preservation. A
charitable legacy requires substantial planning as well.
While each business and owner is unique, certain patterns and truths are universal. During the 170
years J.P. Morgan has been advising wealthy families around the world, we have had the privilege of
assisting business owners in every phase of their operations and through all market conditions. At
whatever stage you may be in the shift from wealth generation to wealth preservation, and whatever
your hopes for your business, fortune and family, it would be our privilege to share the benefit of our
experience with you.
36
36
Eye on the Market
Eye on the Market


J.P. MORGAN
J.P. MORGAN
Eye on the market • J.P. Morgan
Appendix I: Chinese government subsidies
Appendix I: Chinese government subsidies
Government subsidies are often an under-appreciated contributor to the challenges that businesses can
Government
subsidies
are often
an under-appreciated
to the
challengesfrom
thatgovernmentbusinesses
face.
Sometimes,
an industry
leader
in the OECD endscontributor
up facing stiff
competition
6
face.
Sometimes,
an
industry
leader
in
the
OECD
ends
up
facing
stiff
competition
from
governmentsupported firms in other countries. Here’s a look at the impact of Chinese subsidies6:
supported firms in other countries. Here’s a look at the impact of Chinese subsidies :
• At most Chinese solar, steel, glass, paper and auto parts companies, labor costs only make up 2%
• At
mostofChinese
solar, steel,
glass,Nevertheless,
paper and auto
partscompetition
companies, from
laborChina
costs only
upfrom
2%
to 7%
total production
costs.
intense
oftenmake
comes
to
7%
of
total
production
costs.
Nevertheless,
intense
competition
from
China
often
comes
from
small Chinese firms with limited economies of scale, and whose products sell in the international
small
Chinese
in these
sectorstowith
limited
economies of scale, and whose products sell in
market
at 25%firms
to 30%
discounts
world
prices.
international
markets
at
25%
to
30%
discounts
to world prices.
• How can this be explained? In all likelihood, by subsidies
received from the Chinese government.
In all
by artificially
• Subsidies
How can this
takebe
theexplained?
form of free
or likelihood,
low-cost loans;
cheap
raw materials,
components,
Government
subsidies
to Chinese
firms, 1985-2005
subsidies
from the
Chinese
Annual,
$ bn cheap) exchange rate. Land grants
Cumulative, $ bn
energy
orreceived
land; support
for R&D;
and a heavily managed
(i.e.,
$25
$350
government.
Subsidies
take
the
form
of
free
or
for office or factory construction are particularly valuable, since companies can develop excess
low-cost
loans;
artificially
cheap
raw
materials,
$300
parcels and use the proceeds to pay for R&D. As per
$20a June 2013 article in The Wall Street Journal
components,
energy
or
land;
support
for
R&D;
$250
Chinese government subsidies grew 23% y/y in 2012 (following on 24% y/y growth in 2011),
and a heavily
managed
(i.e.,Chinese
cheap) exchange
benefiting
90%
of all listed
companies. $15
$200
rate. Landingrants
office
• Example:
2000, for
China
wasorafactory
net importer of steel. By 2007, China became the world’s largest
$150
$10
construction
areconsumer,
particularlyand
valuable,
since
steel
producer,
exporter.
Energy subsidies to Chinese steel manufacturers were $27
$100
companies
develop excess
parcels its
and
use
billion
fromcan
2000-2007.
Even though
fragmented
$5steel industry has limited economies of scale
the proceeds
for R&D. Theedge,
bar chart
and
not muchtoofpay
a technological
Chinese steel sells for 25% less than US and European steel. $50
shows estimates of these subsidies through
$0
$0
• A similar outcome is seen in the Chinese paper industry,
which received $33 billion in subsidies
2005 from the China Statistical Yearbook; the
1985
1989
1993
1997
2001
2005
from 2002 to 2009. As solar PV, the 5 largest Chinese
companies
received
the equivalent
$31Haley,
Source:
“Subsidies to Chinese
Industry”,
Usha Haley andof
George
series was discontinued in 2006.
Oxford University
Press, April
2013. and other subsidies
billion in low-interest loans from the state-owned China
Development
Bank,
• from
Another
data provider
estimates
Chinese These amounts dwarf the amounts provided by the US
national
and provincial
governments.
government
subsidies
to
public
companies,
and according to their findings, these subsidies are still
government to its solar companies.
growing rapidly. As per a June 2013 article in The Wall Street Journal citing this source, Chinese
government
subsidiessubsidies
grew 23%toy/y
in 2012
(following on 24% y/y growth in 2011), benefiting
Estimated
government
Chinese
firms
90%
of
all
listed
Chinese
companies.
Annual, $ bn
Cumulative, $ bn
•$25 Example: in 2000, China was a net importer of steel.$350
By 2007, China became the world’s largest
steel producer, consumer, and exporter. Energy subsidies
to Chinese steel manufacturers were $27
$300
$20 billion from 2000-2007. Even though its fragmented steel industry has limited economies of scale
and not much of a technological edge, Chinese steel$250
sells for 25% less than US and European steel.
$15
$200 which received $33 billion in subsidies
• A similar outcome is seen in the Chinese paper industry,
from 2002 to 2009. As solar PV, the 5 largest Chinese
$150companies received the equivalent of $31
$10
billion in low-interest loans from the state-owned China Development Bank, and other subsidies
$100
from national and provincial governments. These amounts dwarf the amounts provided by the US
$5
$50
government to its solar companies.
$0
$0
China
is not the
only country
that1997
provides2001
subsidies2005
to domestic
industry; the US does as well
1985
1989
1993
(particularly
to its
auto industry),
andHaley
the and
entire
OECD
engages in substantial subsidies for agricultural
Source: “Subsidies
to Chinese
Industry”, Usha
George
Haley,
7
Oxf ord
April 2013.
. University
But in Press,
our view,
the China case has no equal in terms of scope, breadth and impact.
firms
China
is not
theof
only
that provides
subsidies
to domestic
the US does
as well
Another
aspect
thecountry
China competitive
story:
copyright
and IPindustry;
infringement.
According
to a 2011
(particularly
to itsUnited
auto industry),
and the entire
OECD
engages US
in substantial
for agricultural
report from the
States International
Trade
Commission,
IP-intensivesubsidies
firms conducting
7
. But
in ourinview,
China losses
case has
no equal
of scope,
firms
business
in China
2009the
reported
of $48.2
billionininterms
lost global
sales,breadth
royalties and
and impact.
license fees
due to intellectual property right infringement in China.
Another aspect of the China competitive story: copyright and IP infringement. According to a 2011
report from the United States International Trade Commission, US IP-intensive firms conducting
business in China in 2009 reported losses of $48.2 billion in lost global sales, royalties and license fees
due to intellectual property right infringement in China.
6
From “How Chinese Subsidies Changed the World”, Usha Haley (West Virginia University) and George T. Haley,
From “How
Chinese
Subsidies
Changed the World”, Usha Haley (West Virginia University) and George T. Haley,
Harvard
Business
Review,
April 2013.
Harvard Business Review, April 2013.
7
According to an article in The Economist in September 2012, countries like Norway, Switzerland, Japan and
7
According
an article
in Theto
Economist
in September
Norway,
Switzerland,
Japan
and
South
Koreato
provide
subsidies
their agricultural
sectors2012,
equalcountries
to 45% -like
60%
of gross
farm receipts.
The
EU
South
Korea
provide
subsidies
to
their
agricultural
sectors
equal
to
45%
60%
of
gross
farm
receipts.
The
EU
registers at 20% and the US at 8%.
registers at 20% and the US at 8%.
6
37
37
37
Eye o
n tthe
he M
a r k e t  •J . J.P.
P . MMorgan
ORGAN
Eye
on
market
Appendix II: Biotech and Life Sciences
As mentioned in the Health Care section on page 19, while 2000-2001 was the peak distress period for
biotech and life science companies, there has been a steady drumbeat since, with over 100 biotech and
life science catastrophic loss events since 2002 (see bar chart). We referenced earlier research showing
that even when a drug finally gets to Phase 3 trials, the probability of failure can still be as high as
50%. One possible emerging challenge for the biotech industry: patent trolls. For funding and other
reasons, some universities are under pressure to monetize their patents by transferring rights to
“assertion entities”. As per a 2014 paper from the University of California Hastings College of Law, as
these patent sales take place, the risk to biotech and pharmaceutical companies with existing products
on the market increases dramatically. Such patents can cover active ingredients of drugs, methods of
treatment, screening methods to identify new drugs, manufacturing methods and dosage forms.
In the table, we show some of the more recent catastrophic losses (companies reaching the 70%
decline threshold in 2012 or 2013). Biotech companies can experience periods of depressed stock
prices as trials fail or have to be rerun, with some surging when/if success eventually occurs, or when
they are bought by larger companies. As a result, the table below captures catastrophic loss at a point
in time (Spring 2014), and does not represent a final assessment of each firm’s future prospects.
Health Care companies that reached the 70% loss threshold
in a given year, 1980-2014, Number of stocks
60
50
Pharmaceuticals
Lif e Sciences Tools & Services
Health Care Equipment & Supplies
40
Biotechnology
30
20
10
0
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013
Source: JPMAM, FactSet. February 2014.
38
A Partial List of Russell 3000 Index Biotech and Life
Science Companies reaching catastrophic loss thresholds
in 2012 and 2013
Company
Product / Treatment
Disease / Condition
Affymax
Anthera
AVEO
BG Medicine
Coronado
Cytori
Dynavax
Infinity
Myrexis
Omontys
Varesplaib, Blisibimod
Tivozanib
Galectin-3 Test
TSO
Athena
Heplisav
IPI-145
Azixa
Chronic kidney disease
Heart disease, Lupus
Kidney cancer
Heart failure
Crohn's disease
Coronary heart disease
Hepatitis B
Blood cancer
Brain cancer
Source: FactSet, J.P. Morgan Asset Management.
38
E ye o n t h e M a r k e t

J.P. MORGAN
Eye on the market • J.P. Morgan
Sources
Ailawadi K, Zhang J, Krishna A, and Kruger M, "When Walmart Enters: How Incumbent Retailers React
and How This Affects Their Sales Outcomes," Journal of Marketing Research, June 2009.
“Agricultural subsidies”, The Economist, September 22, 2012.
“Boom and Bust in Telecommunications”, Couper, Hejkal and Wolman, Federal Reserve Bank of
Richmond, 2003.
“Chinese Industrial Subsidies Grow 23%”, Wall Street Journal, June 23, 2013.
“Generic Drug Savings in the US”, Generic Pharmaceutical Association, 2013 Report
“The Growth of Chinese Exports: An Examination of the Detailed Trade Data”, Board of Governors of the
Federal Reserve System International Finance Discussion Papers, November 2011, Berger and Martin
“How Loyal Are Your Customers? A View of Loyalty Sentiment Around the World”, The Nielsen
Company, November 2013.
“The Impact of the Internet on Advertising Markets for News Media”, Athey, Calvano and Gans,
University of Toronto and NBER, 2013.
“Patent Trolling: Why Bio and Pharmaceuticals are at Risk”, Feldman (University of California Hastings
College of Law) and Price (Petrie-Flom Center for Health Law Policy at Harvard Law School), February
2014
Pisano, G. Science Business: The Promise, the Reality, and the Future of Biotech, Harvard Business School
Press, Cambridge, MA; 2006.
United States International Trade Commission, Investigation No. 332-519, “China: Effects of
Intellectual Property Infringement and Indigenous Innovation Policies on the US Economy”, May 2011.
39
39
Eye
market
Morgan
E y e on
o n tthe
he M
a r k e t  •J .J.P.
P. M
ORGAN
Acronyms
BEA: Bureau of Economic Analysis
CLEC: Competitive local exchange carrier
CLTV: Combined Loan to Value
CRSP: Center for Research in Security Prices
DTI: Debt-To-Income; E&P: Exploration and Production
EIA: Energy Information Administration
EPA: Environmental Protection Agency
FCC: Federal Communications Commission
FDA: Food and Drug Administration
FDIC: Federal Deposit Insurance Corporation
FHA: Federal Housing Administration
GAO: Government Accountability Office
GDP: Gross Domestic Product
GICS: Global Industry Classification Standard
GSE: Government-Sponsored Enterprise
HUD: US Department of Housing and Urban Development
IP: Intellectual Property
IPO: Initial Public Offering
JPMAM: J.P. Morgan Asset Management
LCD: Liquid Crystal Display
MMbtu: Million British Thermal Units
MWh: Megawatt-hour
OECD: Organisation for Economic Co-operation and Development
OPEC: Organization of the Petroleum Exporting Countries
PV: Photovoltaic
R&D: Research and Development
REIT: Real Estate Investment Trust
S&P: Standard & Poor’s
SEC: Securities and Exchange Commission
40
40
Eye on the market • J.P. Morgan
Michael ceMbalest is Chairman of Market and Investment Strategy for J.P. Morgan
Asset Management, a global leader in investment management and private banking
with $1.6 trillion of client assets under management worldwide (as of December 31,
2013). He is responsible for leading the strategic market and investment insights across
the firm’s Institutional, Funds and Private Banking businesses.
Mr. Cembalest is also a member of the J.P. Morgan Asset Management Investment
Committee and a member of the Investment Committee for the J.P. Morgan
Retirement Plan for the firm’s more than 250,000 employees.
Mr. Cembalest was most recently Chief Investment Officer for the firm’s Global Private
Bank, a role he held for eight years. He was previously head of a fixed income division
of Investment Management, with responsibility for high grade, high yield, emerging
markets and municipal bonds.
Before joining Asset Management, Mr. Cembalest served as head strategist for Emerging
Markets Fixed Income at J.P. Morgan Securities. Mr. Cembalest joined J.P. Morgan in
1987 as a member of the firm’s Corporate Finance division.
Mr. Cembalest earned an M.A. from the Columbia School of International and Public
Affairs in 1986 and a B.A. from Tufts University in 1984.
41
Eye
market
E y e on
o n tthe
he M
a r k e t  •J .J.P.
P . MMorgan
ORGAN
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herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the
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Further, the views expressed herein may differ from that contained in J.P. Morgan research reports. The
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41
The Agony and the Ecstasy is a 1961 biographical novel by American author Irving Stone on the life of Michelangelo:
his passion, intensity and perseverance as he created some of the greatest works of the Renaissance period.
Like Michelangelo’s paintings and sculptures, successful businesses are the by-product of inspiration, hard work,
and no small amount of genius. And like the works of the Great Masters, only a small minority stand the test of
time and last over the long run. The Agony and the Ecstasy conveys the disparate outcomes facing concentrated
holders of individual stocks in a world, like Michelangelo’s, that is beset with intrigue, unforeseen risks, intense
competition and uncertainty.